FINANC 3000 1st Edition Lecture 17 Outline of Last Lecture I. Measuring Market RiskII. Risk and ReturnIII. Security Market LineIV. CAPMV. Portfolio BetaVI. Capital Market EfficiencyOutline of Current Lecture I. The Cost of CapitalII. Internal vs. External Common EquityIII. Cost of DebtIV. Calculating WeightsV. Estimating International Paper’s Cost of CapitalCurrent LectureFirm’s Cost of Capital- Capital is the term for funds that firms use. Capital is raised from investors and creditors- Why does a firm need to know its cost of capital?- To select the projects and products with high enough expected rate of return that exceeds its cost of capital- The goal of the financial manager to provide the highest possible return to its investorsThe Cost of CapitalThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.- The Weighted Average Cost of Capital is given by:o - Another way of expressing this is:o iwacc= wequity x iequity + wdebt x idebt x(1 – Tc)Component Cost of Equity and CAPM- Can use CAPM model to calculate required return on equityo- If we assume that the firm is a constant growth firm, we can use constant growth model to estimate required rate of returno- CAPM is used more widelyInternal vs. External Common Equity- Corporation may either retain earnings or pay them out as dividends- Retained Earnings are internal common equity- Retained earnings have a cost because investors could earn returns on alternative investments- Selling new equity is external equity capital, has higher cost than internal equity capital because of flotation costsFlotation Costs- Flotation costs - fees paid by firms to investment banks for issuing new securities.- Company receives less money from sale of equity raising the cost of equity- Can adjust for flotation costs by subtracting them from the price of the stock in constant growth model- No direct way to do with CAPM, can use constant growth model to find and then add to CAPM- Average floatation cost 6.5% for equity and 2.5% for bondsPreferred Stock- Can use simplified constant growth equation to calculate cost of capital for preferred stockso- Should be greater than id x (1 −T), because preferred stock is riskier than debt and its dividends are not tax-deductible.After Tax Cost- Interest is tax deductible, unlike dividends- If your company borrows $100,000 and has to pay 10% interest on the loan, let’s calculate after tax cost of capital o- Interest is $10,000 but only caused $6,600 decline in after tax income, so actual cost of capital is 6.6% not 10%Cost of Debt- Two steps to calculating cost of debto Calculate before tax cost of debto Adjust it to convert to after tax rate of return- If bond then to calculate before tax cost of debt, find the yield to maturity- Then to find after tax cost of debt – YTM x (1-Tc)- If bank loan, then to calculate after tax cost of loan, multiply id x (1-Tc)- We will use 34% as a tax rateCalculating Weights- Need to calculate percentage of funding that come from common stock, preferred stock and debt- Compute this percentage based on MARKET value of equity and debt, NOT book value when computing WACC for the company- For a project only include financing used to finance a project in proportion usedoEstimating International Paper’s Cost of Capital- First, we estimate the cost of equity and the cost of debt.o We estimate an equity beta to estimate the cost of equity.o We can often estimate the cost of debt by observing the YTM of the firm’s debt.- Second, we determine the WACC by weighting these two costs appropriately.- The industry average beta is 0.82; the risk free rate is 8% and the market risk premium is 9.2%. - Thus the cost of equity capital iso E(r)=RF+Bi x (Rm-RF)oo- The yield on the company’s debt is 8% and the firm is in the 37% marginal tax rate.- The firm has bonds outstanding with a book value of $50 million. They have a coupon rate of 10% and a yield to maturity of 8%, thus they trade at 120% of par. Market value = $60m- The firm has 10 million shares outstanding with a par value of $1; they trade at $12.75 per share. Market Value = $127.5m- Thus, the debt to value ratio(weight for debt) is thus 32%:o- The firm is in the 37% marginal tax rate.o Iwacc=wequity+iequity+wdebt x idebt x (1-Tc)o- 12.18 percent is International’s cost of capital. It should be used to discount any project where one believes that the project’s risk is equal to the risk of the firm as a whole, and the project has the same leverage as the firm as a whole.Interpreting the WACC- It should be used to discount any project where one believes that the project’s risk is equal to the risk of the firm as a whole, and the project has the same leverage as the firm as a whole. ≈ Return on Assets reflects firm’s risk- Why not all debt?- Higher level of debt → higher risk = more expensive- Higher level of debt → higher required equity return=8 % +0 . 82×9 . 2 %=15 . 54 %DV=DD+E=$ 60 m$ 60 m+127 . 5 m=0. 32=0 . 68×15 . 54 % +0 .32×8 %×(1−.37 )=12 .18