Managerial Finance CH 14 - Cost of Capital
WACC
Cost of equity
Cost of Debt
Cost of Preferred stock
Importance
Risk of As -> Returned earned
indication how market views risk of As
helps determine required return for projects
required rate of return = cost of capital
return required by investors given risk of cash flows from firm
Required return on firm debt - LT debt/bonds
Cashflow from firm
Dividends (periodic)
Selling shares (terminal)
Dividend growth model (DGM)
SML or CAPM
Dividends have to be issued and grow at a stable rate to use
Re = D1/P0 + g
Pros and Cons
Easy to use
Has to meet conditions
Sensitive to changes in estimated g
Does not consider risk
Estimation of g
Find arithmetic or geometric averages of past Ds
g = retention ratio * ROE
*Can be used when firm has stable RO, D policy, and not planning to raise new external capital
Pros and Cons
adjusts for systematic risk
Applies to all firms (if we have beta)
Re = Rf + Be * [ E(Rm) - Rf ]
Many of the variables used vary over time
Uses past data, its not reliable to predict future
If models differ use average of two rates or SML
Estimated by finding YTM on debt
Cashflows through coupoons and selling bonds
Coupon rate=/=
Rp = D/ P0
Average cost of capital of firm
WACC = We x Re + Wd x Rd x (1-Tc)
Determining weights
Target D/E Ratio
Market Value of Debt and Equity
We = E/V, Wd = D/v
Impact of Taxes
Interest expense of debt reduces tax liability -> smaller cost of debt
Divisional and Projects
Use fIrm's WACC to evaluate projects with similar risk
Different divisions will require different rates (each has differ risk)
Pitfall of using one WACC
More acceptance of risky projects
and rejection of less risky projects
Subjective solution
Pure Play solution
Use WACC of peer firm that specializes in that project
Hard to find such firms
Set discount rates for projects depending if projects are more/less risker then firm
It brings LOWER rate of incorrect accept/reject of projects
Valuing a company
Calculate adjusted CFA*
Find firm value at future data
EBIT x (1 -Tc) + Depreciation - Change in NWC -Capital spending
Assume it is expected to grow at constant rate
CFA* (t+1) / WACC - g
Value firm using
Flotation Costs
Cost of issuing new equity/debt
Total raised by company = Amount to be raised / 1- flotation cost
Basic approach
Use target weights b/c firms issue securities in these %s over the LT
Internal Equity
Still use target D/E ratio
Fe = 0, flotation for equity = 0