I Chapter 14 Cost of Capital a Cost of Capital the estimated cost of funding that the firms use to finance most of their investments in real assets i Cost of NEW funding for investments ii AKA required rate of return for projects the firm considers undertaking 1 Also called the discount rate 2 Projected cash flows are discounted to PV and summed they must 0 for project to be acceptable b Steps Estimating a Firm s Cost of Capital cost i Estimate the after tax 1 Cost of Equity of the long term financing sources a Difficult to estimate Required Rate of Return Firm s Cost of Equity It is hard to estimate the Risk Premium thus it is hard to estimate the firm s cost of equity b Different Approaches i Constant Growth Dividend Valuation Model Approach 1 eps dps will grow at constant rate for indefinite period of 2 Cost of Equity Dividend Next Year Current Selling Price time Growth Rate ii CAPM Approach 1 Cost of Equity depends on Systematic Risk Market risk 2 Cost of Equity Risk Free Rate Risk Premium of Market Beta a Risk Premium of Market Expected Return on the Market Risk Free Rate iii Equity Risk Premium Approach 1 Cost of Equity Firms before tax cost of debt Equity risk premium a Firms before tax cost of debt YTM on the debt b Find I in TVM This YTM on the debt 2 Equity is risker then debt from perspective of investor before tax cost of debt is good base in which to start Differences in risk across firms are reflected in differences in the cost of debt 2 Cost of Debt After Tax a After Tax Cost of Debt YTM 1 tax rate i YTM I in TVM Before tax cost of debt ii After tax more relevant than before tax 3 Cost of Preferred Stock a Cost of Preferred Stock Annual Dividend Price per Share i Annual Dividend of preferred stock value of stock ii Determine the weight applied to each source of financing Ways to do this 1 Management specifies Target Capital Structure a The desired mix of long term financing sources that a firm desires to use in its capital structure 2 Calculating the MV of the firm s long term debt equity and preferred stock then figuring out what each source represents out of total Value a Ex Weight of Debt MV of Debt MV Total 3 Book Values of debt equity from balance sheet a use MV before BV iii Calculate the Weighted Average Cost of Capital WACC 1 WACC Weight of Debt Cost of Debt before taxes 1 tax rate Weight of preferred stock Cost of preferred stock after taxes Weight of equity Cost of equity after taxes c Other Issues Pertaining to the Cost of Capital i Flotation Costs Costs occurred when raising funds 1 Arise when firms issue new securities for purpose of raising funds a Fees paid to investment bankers who help the firm raise capital 3 10 i Lower for preferred stock and bonds b Not considering will lead to higher NPV 2 How should flotation costs be treated for capital budgeting purposes a Total floatation costs should be added to initial outlay NPV should be calculated as before Lead to a reduction in a proposal s NPV if incorporated into the analysis b 3 No inflation costs w equity raised internally retention of earnings for reinvestment purposes firms existing assets those lower ii WACC correct discount rate to use in capital budgeting when current project risk avg risk of 1 After tax costs of debt preferred and equity reflect risk of firm s existing assets 2 For projects riskier than normal a rate higher than WACC would be used Vice Versa for II Chapter 16 Capital Structure a Capital Structure finance mix used by the firm to finance its assets typically only Debt Equity i Does the Cap Structure have an effect on shareholders wealth Is there a particular mix of debt equity financing that maximizes expected value of the stock 1 Look at Does the total value of the firm MV Debt MV equity change as the debt Equity mix changes a Correct decision debt Equity mix that maximizes total value of the firm i Corresponds to lowest WACC correct discount rate when discounting firm s overall cash flows for valuation purposes b Effect of Using Debt Financing Financial Leverage It Increase risk on SH claims greater variability in eps and return on equity for the shareholder It Increases risk of shareholder expected rate of return measured by eps or roe i ii iii Effects of a firm using debt financing are similar to effects on claims of an investor when they purchase securities on margin borrowing money to purchase stock There is risk in both iv Why does debt financing result in higher expected eps and a higher expected roe 1 If Operating return on assets interest rate on debt then eps and roe will be greater for the plan w more debt financing v Breakeven Analysis for Alternative Plans Indifference point 1 Earnings before interest and taxes Breakeven Point share B shares B shares A Interest expenses of A share A shares A shares B Interest expenses of B 2 Eps breakeven point earnings before interest and taxes breakeven point interest expense 1 t of shares 3 Relationship between EBIT and eps is linear a Easiest ways to draw relationships Indifference point and level at which EBIT produces an eps 0 i interest expense for the plan 4 If EBIT EBIT Breakeven point then the more highly levered plan has higher eps Vice Versa a As EBIT changes eps of more highly levered plan will exhibit greater viability 5 GRAPH c Business risk vs Financial risk i Business risk risk inherent in the firms operations 1 Not affected by how a firm finances its assets 2 Determined by capital budgeting decisions that have been made through time a Determine the nature of the business the firm conducts 3 Fluctuating sales and costs cause eps to be uncertain overtime a Uncertainty in eps due to the nature of the business 4 Some firms have more business risk ii Financial Risk financing additional risk associated w shareholders claims attributed to the firms debt 1 The added variability in eps that shareholders face due to use of financial leverage iii If a firm is all equity then business risk is distributed across all shareholders 1 If the same firm allows debt financing into the mix then the same business risk is distributed among fewer shares thus risk of the stock claim increases d Does an Optimal Capital Structure Exist i It would depend on whether here is a particular mix that minimizes the WACC the value of the firm Two Abstracts thus maximizing 1 World w o taxes and bankruptcy costs a Mix of debt and equity does not affect WACC or firm value b No optimal capital structure capital structure decisions are irrelevant i
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