FIN 3303 1st Edition Exam 2 Study Chapter 6 Cost of Capital o Issuing Debt bonds o Issuing Equity stocks o Weighted Average cost of Capital Cost of Capital Definition and Components o What is Cost of Capital A firm demands capital that it needs for investment Suppliers Common Shareholders Preferred Shareholders Bondholders Capital is not free Cost of capital is the return that the suppliers of capital require from the firm The firm cares because cost of capital is the benchmark return on its investment projects o Cost of Common Equity How do shareholders of the firm receive value Firm invests and earns returns Firm pays dividends to shareholders Shareholders invest cash in a financial asset of comparable risk Conclusion The firm must earn at least as much as an alternative financial assets with equal risk Shareholders required return Equity Cost of Capital o Cost of Preferred Equity and Debt Similarly cost of preferred equity is the return required by preferred shareholders Similarly cost of debt is the return or the yield required by bondholders WACC Weighted Average Cost of Capital Definition and Components o Weighted Average Cost of Capital Let wd wp wc be the proportions of debt preferred stock and common stock that the firm s financing consist of respectively we call them weights Let rd rp rc be the rates of return required by bondholders preferred shareholders and common shareholders respectively Let T be the income tax rate Importantly interest expense on debt is tax deductible but dividends are not Then the firm s weighted average cost of capital is WACC wdrd 1 T wprp wcrc o How are the weights determined WACC wdrd 1 T wprp wcrc Use accounting numbers or market value book vs market weights Use actual numbers or target capital structure o How is Cost of Debt determined One can look up the yields on the firm s bonds Not 100 accurate Liquidity Data availability Private debt opposed to public debt o How is Cost of Preferred Equity determined We can find it as the discount rate from the perpetuity formula PV C r o In this case PV is the price of preferred share o C is the promised dividend o Then r is the cost of preferred equity o How is Cost of Common Equity determined Using the CAPM rc Rf c Rm Rf WACC Example and Calculation o Given Tax Rate 40 15 year 12 semiannual coupon bonds sell for 1 153 72 10 100 par value perpetual preferred stock sells for 111 10 1 2 Rf 7 Rm 13 Target Financing 30 debt 10 preferred 60 Common equity N 30 I Y 5 PV 1153 72 PMT 60 FV 1000 rd 5 x 2 10 rd 1 T 10 1 4 6 o Cost of Preferred Stock rp 10 100 par value perpetual preferred stock sells for 111 10 rp Dp Pp rp 10 111 10 9 o Cost of Common Equity rc rc Rf c Rm Rf 7 1 2 13 7 14 2 o Weighted Average Cost of Capital WACC wdrd 1 T wprp wcrc 3 6 1 9 6 14 2 1 8 9 8 52 11 22 WACC and Firm Value o Suppose WACC 14 2 o Suppose firm has perpetual annual cash flow of 20 million 12 million to bondholders 1 million to preferred shareholders 7 million to common shareholders Value of Firm o PV 20 142 140 85 million What if WACC were 13 15 o PV 20 13 o PV 20 15 Conclusion The lower the WACCC the higher the firm value o What affects WACC Investment policy is the major factor Investing in projects with higher risk raises WACC Market conditions affect WACC Effect on interest rates Effect on risk aversion Effect on market risk Can dividend policy and capital structure policy affect WACC WACC as Hurdle Rate o WACC as the Hurdle Rate WACC reflects the risk of an average project undertaken by the fir Therefore the WACC only represents the hurdle rate for a typical project with average risk Different projects have different risks The projects WACC should be adjusted to reflect the project s risk o The Firm vs The Project o S should be SML Hurdle rate WACC Project in red dots Would be rejected because its below hurdle rate Low risk project Project in green dots Would be accepted because above hurdle rate High risk project o If you determined everything by risk then the outcome would be different Conclusion WACC is the benchmark return Lower WACC means higher firm value WACC is affected by firm policies and market conditions WACC is the hurdle rate It is good for evaluating projects of average risk Project specific WACC should account for project risk Chapter 7 Payback Period o Payback Period Rule How long does it take the project to pay back its initial investment Payback period number of years to recover initial costs Minimum Acceptance Criteria Set by management Ranking Criteria Set by management o Example Consider a project with the following cash flows Find the payback period o Payback is between 2 and 3 years 2 5 years At 2 years we re at 45 000 30 000 15 000 Payback Period Rule Disadvantages Ignores time value of money Ignores cash flows after the payback period Biased against long term projects Requires an arbitrary acceptance criteria Advantages Easy to understand Biased toward liquidity Net Present Value o Net Present Value NPV Total PV of future Cash Flows Initial Investment Estimating NPV Estimate size and timing of future cash flows Estimate discount rate Estimate initial costs Minimum acceptance criteria Accept if NPV 0 Ranking criteria Choose the highest NPV o The NPV Rule Example ABC is considering investing in a riskless project costing 100 The project receives 107 in one year and has no other cash flows The interest rate is 6 Find the NPV of the project NPV 100 107 1 06 0 94 How much does the project add to the firm value 94 cents What is the discount rate if the project is risky Depends on how risky the project is Discount rate is likely to be higher than 6 o Which Discount Rate to Use The proper discount rate should be commensurate with the systematic risk of the firm s cash flows That is the rate that the stakeholders expect to earn on an alternative financial asset of similar systematic risk E g for an all equity if the CAMP holds the true discount rate is found from the CAPM For a firm that has debt the true discount rate is the WACC adjusted for risk o Advantages Uses cash flows Uses ALL cash flows of the project Discounts ALL cash flows properly Reinvestment assumption the NPV rule assumes that all cash flows can be reinvested at the discount rate Internal Rate of Return o IRR The discount rate that sets NPV to zero Suppose you invest 100 and receive 130 in one year IRR 0 100 130 1 IRR o IRR 30 Minimum Acceptance Criteria Accept if the IRR exceeds the require return Ranking Criteria Select