Chapter 14 Cost of Capital - PDF

CHAPTER 14 Cost of Capital  LEARNING OBJECTIVES After studying this chapter, you should understand:  How to determine a firm’s cost of equity capital.  How to determine a firm’s cost of debt.  How to determine a firm’s overall cost of capital and how to use it to value a company.  How...

CHAPTER 14 Cost of Capital  LEARNING OBJECTIVES After studying this chapter, you should understand:  How to determine a firm’s cost of equity capital.  How to determine a firm’s cost of debt.  How to determine a firm’s overall cost of capital and how to use it to value a company.  How to correctly include flotation costs in capital budgeting projects.  Some of the pitfalls associated with a firm’s overall cost of capital and what to do about them. 14.1 The Cost of Capital: Some Preliminaries  In Chapter 13, the Security Market Line (SML) was developed to explore the relationship between expected return on a security and its systematic risk.  The previous focus was from the viewpoint of investors, helping to understand alternatives available in capital markets.  Now, the focus shifts to how returns and securities are viewed from the perspective of companies issuing them.  Key point: The return an investor receives is the cost of the security to the issuing company. Required Return vs. Cost of Capital:  Required return on an investment (e.g., 10%) means the investment will only have a positive NPV if its return exceeds this rate.  Required return can also be interpreted as the rate a firm must earn to compensate investors for the use of capital.  For a risk-free project, the required return is equal to the risk-free rate.  For a risky project, the required return (and cost of capital) will be higher than the risk-free rate.  Terms such as required return, appropriate discount rate and cost of capital are used interchangeably as they essentially mean the same thing.  The cost of capital depends primarily on the risk of the investment, not on the source of the capital.  The cost of capital is influenced by the use of the funds, not how or where the capital is raised. Financial Policy and Cost of Capital: A firm’s capital structure (mixture of debt and equity) is a managerial decision. This chapter assumes the firm maintains a fixed debt- equity ratio reflecting its target capital structure. The firm’s overall cost of capital reflects the required return on the firm’s assets as a whole. Since a firm uses both debt and equity, its overall cost of capital is a mixture of returns needed to compensate creditors and stockholders. 14.2 The Cost of Equity We begin with the most difficult question on the subject of cost of capital: What is the firm’s overall cost of equity? The reason this is a difficult question is that there is no way of directly observing the return that the firm’s equity investors require on their investment. Instead, we must somehow estimate it. This section discusses two approaches to determining the cost of equity: the dividend growth model approach and the security market line (SML) approach. THE DIVIDEND GROWTH MODEL APPROACH The easiest way to estimate the cost of equity capital is to use the dividend growth model we developed in Chapter 8. Recall that, under the assumption that the firm’s dividend will grow at a constant rate, g, the price per share of the stock, P0, can be written as: where D0 is the dividend just paid and D1 is the next period’s projected dividend. Notice that we have used the symbol RE (the E stands for equity) for the required return on the stock. As we discussed in Chapter 8, we can rearrange this to solve for RE as follows: / Because RE is the return that the shareholders require on the stock, it can be interpreted as the firm’s cost of equity capital. Implementing the Approach To estimate RE using the dividend growth model approach, we obviously need three pieces of information: P0, D0, and g.2 Of these, for a publicly traded, dividend-paying company, the first two can be observed directly, so they are easily obtained. Only the third component, the expected growth rate for dividends, must be estimated. To illustrate how we estimate RE, suppose Greater States Public Service, a large public utility, paid a dividend of $4 per share last year. The stock currently sells for $60 per share. You estimate that the dividend will grow steadily at a rate of 6 percent per year into the indefinite future. What is the cost of equity capital for Greater States? Using the dividend growth model, we can calculate that the expected dividend for the coming year, D1, is: Given this, the cost of equity, RE, is: The cost of equity is thus 13.07 percent. Estimating g To use the dividend growth model, we must come up with an estimate for g, the growth rate. There are essentially two ways of doing this: (1) Use historical growth rates or (2) use analysts’ forecasts of future growth rates. Analysts’ forecasts are available from a variety of sources. Naturally, different sources will have different estimates, so one approach might be to obtain multiple estimates and then average them.  Alternatively, we might observe dividends for the previous, say, five years, calculate the year-to-year growth rates, and average them. For example, suppose we observe the following for some company:  We can calculate the percentage change in the dividend for each year as follows: Notice that we calculated the change in the dividend on a year- to-year basis and then expressed the change as a percentage. Thus, in 2011 for example, the dividend rose from $1.10 to $1.20, an increase of $.10. This represents a $.10/1.10 = 9.09%  If we average the four growth rates, the result is (9.09 + 12.50 + 3.70 + 10.71)/4 = 9%, so we could use this as an estimate for the expected growth rate, g. Notice that this 9 percent growth rate we have calculated is a simple, or arithmetic, average. Calculating a geometric growth rate; Here, the dividend grows from $1.10 to $1.55 over a four-year period. What’s the compound, or geometric, growth rate? See if you don’t agree that it’s 8.95 percent; you can view this as a simple time value of money problem where $1.10 is the present value and $1.55 is the future value. As usual, the geometric average (8.95 percent) is lower than the arithmetic average (9 percent), but the difference here is not likely to be of any practical significance. In general, if the dividend has grown at a relatively steady rate, as we assume when we use this approach, then it can’t make much difference which way we calculate the average dividend growth rate. Advantages and Disadvantages of theprimary The Approach advantage of the dividend growth model approach is its simplicity. It is both easy to understand and easy to use. There are a number of associated practical problems and disadvantages.  First and foremost, the dividend growth model is obviously applicable only to companies that pay dividends. This means that the approach is useless in many cases. Furthermore, even for companies that pay dividends, the key underlying assumption is that the dividend grows at a constant rate. As our previous example illustrates, this will never be exactly the case. More generally, the model is really applicable only to cases in which reasonably steady growth is likely to occur.  A second problem is that the estimated cost of equity is very sensitive to the estimated growth rate. For a given stock price, an upward revision of g by just one percentage point, for example, increases the estimated cost of equity by at least a full percentage point. Because D1 will probably be revised upward as well, the increase will actually be somewhat larger than that.  Finally, this approach really does not explicitly consider risk. Unlike the SML approach (which we consider next), there is no direct adjustment for the riskiness of the investment.  For example, there is no allowance for the degree of certainty or uncertainty surrounding the estimated growth rate for dividends.  As a result, it is difficult to say whether or not the estimated return is commensurate with the level of risk. THE SML APPROACH In Chapter 13, we discussed the security market line, or SML. Our primary conclusion was that the required or expected return on a risky investment depends on three things:  The risk-free rate, Rf.  The market risk premium, E(RM) − Rf.  The systematic risk of the asset relative to average, which we called its beta coefficient, β. Using the SML, we can write the expected return on the company’s equity, E(RE), as: where βE is the estimated beta. To make the SML approach consistent with the dividend growth model, we will drop the Es denoting expectations and henceforth write the required return from the SML, RE, as: =+ Implementing the Approach To use the SML approach, we need a risk- free rate, Rf, an estimate of the market risk premium, RM − Rf, and an estimate of the relevant beta, βE. In Chapter 12, we saw that one estimate of the market risk premium (based on large common stocks) is about 7 percent. U.S. Treasury bills are paying about.10 percent as this chapter is being written, so we will use this as our risk-free rate. Beta coefficients for publicly traded companies are widely available. Thus, using the SML approach, we calculate that Abercrombie & Fitch’s cost of equity is about 13.05 percent. Advantages and Disadvantages of the Approach  The SML approach has two primary advantages.  First, it explicitly adjusts for risk.  Second, it is applicable to companies other than just those with steady dividend growth. Thus, it may be useful in a wider variety of circumstances.  There are drawbacks, of course.  The SML approach requires that two things be estimated: the market risk premium and the beta coefficient.  To the extent that our estimates are poor, the resulting cost of equity will be inaccurate.  For example, our estimate of the market risk premium, 7 percent, is based on about 100 years of returns on particular stock portfolios and markets. Using different time periods or different stocks and markets could result in very different estimates.  Finally, as with the dividend growth model, we essentially rely on the past to predict the future when we use the SML approach.  Economic conditions can change quickly; so as always, the past may not be a good guide to the future.  In the best of all worlds, both approaches (the dividend growth model and the SML) are applicable and the two result in similar answers.  If this happens, we might have some confidence in our estimates.  We might also wish to compare the results to those for other similar companies as a reality check. 14.3 The Costs of Debt and Preferred Stock THE COST OF DEBT  The cost of debt is the return the firm’s creditors demand on new borrowing. In principle, we could determine the beta for the firm’s debt and then use the SML to estimate the required return on debt just as we estimated the required return on equity. This isn’t really necessary, however. Cost of debt: Return creditors demand on new borrowing.  Unlike a firm’s cost of equity, its cost of debt can normally be observed either directly or indirectly: The cost of debt is simply the interest rate the firm must pay on new borrowing, and we can observe interest rates in the financial markets.  For example, if the firm already has bonds outstanding, then the yield to maturity on those bonds is the market- required rate on the firm’s debt.  Alternatively, if we know that the firm’s bonds are rated, say, AA, then we can simply find the interest rate on newly issued AA-rated bonds. Either way, there is no need to estimate a beta for the debt because we can directly observe the rate we want to know.  There is one thing to be careful about, though.  The coupon rate on the firm’s outstanding debt is irrelevant here.  That rate just tells us roughly what the firm’s cost of debt was back when the bonds were issued, not what the cost of debt is today.  This is why we have to look at the yield on the debt in today’s marketplace. For consistency with our other notation, we will use the symbol RD for the cost of debt THE COST OF PREFERRED STOCK Determining the cost of preferred stock is quite straightforward. As we discussed in Chapters 6 and 8 , preferred stock has a fixed dividend paid every period forever, so a share of preferred stock is essentially a perpetuity. The cost of preferred stock, RP, is thus: =  Where D is the fixed dividend and P0 is the current price per share of the preferred stock.  Notice that the cost of preferred stock is simply equal to the dividend yield on the preferred stock.  Alternatively, because preferred stocks are rated in much the same way as bonds, the cost of preferred stock can be estimated by observing the required returns on other, similarly rated shares of preferred stock. 14.4 The Weighted Average Cost of Capital THE CAPITAL STRUCTURE WEIGHTS We will use the symbol E (for equity) to stand for the market value of the firm’s equity. We calculate this by taking the number of shares outstanding and multiplying it by the price per share. Similarly, we will use the symbol D (for debt) to stand for the market value of the firm’s debt. For long-term debt, we calculate this by multiplying the market price of a single bond by the number of bonds outstanding.  If there are multiple bond issues (as there normally would be), we repeat this calculation of D for each and then add up the results.  If there is debt that is not publicly traded (because it is held by a life insurance company, for example), we must observe the yield on similar publicly traded debt and then estimate the market value of the privately held debt using this yield as the discount rate.  For short-term debt, the book (accounting) values and market values should be somewhat similar, so we might use the book values as estimates of the market values.  Finally, we will use the symbol V (for value) to stand for the combined market value of the debt and equity: 𝑉 =𝐸 + 𝐷  If we divide both sides by V, we can calculate the percentages of the total capital represented by the debt and equity: 𝐸 𝐷 100 %= + 𝑉 𝑉 These percentages can be interpreted just like portfolio weights, and they are often called the capital structure weights.  For example, if the total market value of a company’s stock were calculated as $200 million and the total market value of the company’s debt were calculated as $50 million, then the combined value would be $250 million.  Of this total, E/V = $200 million/250 million = 80%, so 80 percent of the firm’s financing would be equity and the remaining 20 percent would be debt.  We emphasize here that the correct way to proceed is to use the market values of the debt and equity.  Under certain circumstances, such as when calculating figures for a privately owned company, it may not be possible to get reliable estimates of these quantities.  In this case, we might go ahead and use the accounting values for debt and equity.  Although this would probably be better than nothing, we would have to take the answer with a grain of salt.  TAXES AND THE WEIGHTED AVERAGE COST OF CAPITAL Aftertax Discount Rate: When calculating discount rates for cash flows, the rates must be expressed on an aftertax basis since we're concerned with aftertax cash flows. Corporate interest payments are tax-deductible, unlike payments to stockholders (e.g., dividends). This means the government effectively subsidizes part of the interest cost by reducing the firm's tax bill. Pretax vs. Aftertax Cost of Debt:  The cost of debt must be adjusted for taxes to determine the aftertax cost.  Since interest is tax-deductible, the aftertax cost is lower than the pretax cost.  Example: A firm borrows $1 million at 9% interest, and with a corporate tax rate of 34%, the aftertax interest rate is reduced to 5.94%.  The formula for aftertax cost of debt is: Aftertax cost of debt=RD×(1−TC) Where RD is the pretax cost of debt, and TC is the corporate tax rate. Tax Savings from Debt:  The tax-deductibility of interest payments results in tax savings. In the example, the $90,000 in interest reduces the firm’s tax bill by $30,600, leading to an actual interest cost of $59,400.  The formula for tax savings is: 𝑇𝑎𝑥 𝑠𝑎𝑣𝑖𝑛𝑔𝑠=𝑇𝐶 × 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 Capital Structure Weights:  When calculating a firm's overall cost of capital (WACC), the aftertax cost of debt is combined with the cost of equity, taking into account the capital structure weights (the proportion of debt and equity financing used by the firm).  The adjusted cost of debt (aftertax) and cost of equity are both factored into determining the overall discount rate used for evaluating projects. To calculate the firm’s overall cost of capital, we multiply the capital structure weights by the associated costs and add them up. The total is the weighted average cost of capital (WACC): The weighted average of the cost of equity and the after-tax cost of debt. +(D/V)) This WACC has a straightforward interpretation.  It is the overall return the firm must earn on its existing assets to maintain the value of its stock.  It is also the required return on any investments by the firm that have essentially the same risks as existing operations.  So, if we were evaluating the cash flows from a proposed expansion of our existing operations, this is the discount rate we would use.  If a firm uses preferred stock in its capital structure, then our expression for the WACC needs a simple extension.  If we define P/V as the percentage of the firm’s financing that comes from preferred stock, then the WACC is simply: + (P/V)) where RP is the cost of preferred stock.  CALCULATING THE WACC FOR EASTMAN CHEMICAL Eastman’s Cost of Equity Our first stop is the main screen for Eastman available at finance.yahoo.com (ticker: EMN). As of early 2014, here’s what it looked like:  Next, we went to the “Key Statistics” screen.  According to this screen ,Eastman has 152.42 million shares of stock outstanding.  The book value per share is $24.91, but the stock sells for $86.51.  Total equity is therefore about $3.797 billion on a book value basis, but it is closer to $13.186 billion on a market value basis.  To estimate Eastman’s cost of equity, we will assume a market risk premium of 7 percent, similar to what we calculated in Chapter 12. Eastman’s beta on Yahoo! is 1.80, which is much higher than the beta of the average stock.  To check this number, we went to the well-known Value Line Investment Survey, which uses an approach that moderates very large and very small betas. Here, the beta is reported as a much more reasonable 1.35, which is the number we will use.  According to the Bonds section of finance.yahoo.com, T- bills were paying about.10 percent. Using the CAPM to estimate the cost of equity, we find:  RE =.001 + 1.35 (.07) =.0955, or 9.55% Eastman has paid dividends for only a few years, so calculating the growth rate for the dividend discount model is problematic. However, under the Analyst Estimates link at finance.yahoo.com, we found the following:  Solving for RE, we get 7.43 percent.  Notice that our two estimates for the cost of equity are not identical. This is essentially always the case.  Remember that each method of estimating the cost of equity relies on different assumptions, so different estimates of the cost of equity should not surprise us. Eastman’s Cost of Debt Eastman has eight relatively long-term bond issues that account for essentially all of its long-term debt. To calculate the cost of debt, we will have to combine these eight issues. What we will do is compute a weighted average. We went to www.finra.org/marketdata to find quotes on the bonds. We should note here that finding the yield to maturity for all of a company’s outstanding bond issues on a single day is unusual. If you remember our previous discussion of bonds, the bond market is not as liquid as the stock market; on many days, individual bond issues may not trade. To find the book value of the bonds, we went to www.sec.gov and found the 10K report dated December 31, 2013, and filed with the SEC on February 28, 2014. The basic information is as follows:  To calculate the weighted average cost of debt, we take the percentage of the total debt represented by each issue and multiply by the yield on the issue.  We then add to get the overall weighted average debt cost.  We use both book values and market values here for comparison.  The results of the calculations are as follows:  As these calculations show, Eastman’s cost of debt is 2.89 percent on a book value basis and 2.89 percent on a market value basis.  Thus, for Eastman, whether market values or book values are used makes no difference.  The reason is simply that the market values and book values are similar.  This will often be the case and explains why companies frequently use book values for debt in WACC calculations.  Also, Eastman has no preferred stock, so we don’t need to consider its cost.  WACC =.50 × 8.49% +.50 × 2.89% × (1 −.35) = 5.17%  Thus, using book value capital structure weights (and more decimal points than shown here), we get about 5.17 percent for Eastman’s WACC.  If we use market value weights, however, the WACC will be higher. To see why, notice that on a market value basis, Eastman’s equity and debt are worth $13.186 billion and $4.073 billion, respectively.  The capital structure weights are, t h e re f o re , $13.186 billion/17.259 billion =.76 and $4.073 billion/17.259 billion =.24, so the equity percentage is much higher. With these weights (and more decimal points than shown here), Eastman’s WACC is: WACC =.76 × 8.49% +.24 × 2.89% × (1 −.35) = 6.93%  Thus, using market value weights, we get about 6.93 percent for Eastman’s WACC, which is noticeably larger than the 5.17 percent WACC we got using book value weights.  SOLVING THE WAREHOUSE PROBLEM AND SIMILAR CAPITAL BUDGETING PROBLEMS WACC and Project Risk: Before using the Weighted Average Cost of Capital (WACC) to discount cash flows and estimate Net Present Value (NPV), it is essential to ensure that the WACC reflects the appropriate level of risk for the project. A comparable alternative in financial markets should have the same level of risk as the project, in this case, the warehouse renovation. Projects of the same risk are in the same risk class. WACC Reflects Firm’s Existing Assets:  The WACC represents the risk and target capital structure of the firm’s entire portfolio of assets, not just a single project.  Therefore, the WACC is suitable as a discAount rate only if the new investment, such as the warehouse project, mirrors the firm’s existing operations in terms of risk and business characteristics. Appropriate Discount Rate:  The firm’s WACC can be used as the discount rate only if the proposed investment (e.g., the warehouse renovation) is similar to the firm's existing activities in terms of risk.  If the new project carries a different level of risk, then the 14.5 Divisional and Project Costs of Capital THE SML AND THE WACC The Weighted Average Cost of Capital (WACC) represents the overall cost of capital for a firm, reflecting its typical risk level. However, when evaluating projects or investments that have risks significantly different from the firm’s average risk profile, using the WACC can lead to in This example highlights that, for an all-equity firm with average market risk, the WACC and cost of equity are the same. However, if a firm with this profile evaluates a project with substantially higher or lower risk than the overall company, using the same WACC (15%) would be inappropriate. Correct decisions. The Security Market Line (SML) and the Weighted Average Cost of Capital (WACC)  For example, consider point A. This project has a beta of βA =.60, as compared to the firm’s beta of 1.0. It has an expected return of 14 percent. Is this a desirable investment? The answer is yes because its required return is only:  THE PURE PLAY APPROACH  Pure Play Approach:The pure play approach is used to estimate the required return on an investment by analyzing market-required returns from companies that focus exclusively on a single line of business.  A company focusing on one business type is called a "pure play." For example, if you want to invest in crude oil price movements, you would look for companies that deal exclusively in crude oil, as they are the most sensitive to price changes.  This method helps in estimating the cost of capital for a new business venture by comparing it to companies already operating in that space. For example, if McDonald's entered the computer business, it would Identifying Comparable Companies:  To calculate an appropriate cost of capital, it’s important to identify companies that closely resemble the project or line of business being evaluated.  The goal is to find companies whose business risks align with the project or new business venture. For example, McDonald's would look to Dell, a computer company, rather than HP, which has multiple product lines.  The more closely a company focuses on the desired business, the more reliable the estimate of cost of capital will be. Challenges with the Pure Play Approach:  Finding an appropriate "pure play" company for comparison can be difficult. Sometimes, there are no companies that match the exact business model or project, making it hard to estimate a discount rate objectively.  The key issue is ensuring that mistakes are minimized when using the weighted average cost of capital (WACC) as a blanket cutoff for all investments, which may lead to inaccurate decisions without considering the unique risks of different ventures. 14.6 Company Valuation with the WACC Interest as a Financing Cost, Not an Operating Cost:  When valuing a company, one key distinction is that interest paid on borrowed money is a financing cost, not an operating cost. This means it’s related to the way the company is funded rather than its day-to-day operations.  Interest expenses, while often seen on a company’s financial statements, are not part of the company's operational cash flows and should be considered separately from business operations when assessing Tax Deduction from Interest:  Although interest paid is not an operating cost, it is tax deductible, which reduces the company’s overall tax bill. This tax shield lowers the company’s tax obligations because the debt financing creates an interest expense that reduces taxable income.  When calculating cash flow from assets, it's important to first calculate the company’s tax bill as if it had no debt (i.e., without the interest deduction), to understand the full value before any benefits from the tax shield Our adjusted cash flow, CFA*, is often called “free cash flow,” but as we mentioned much earlier in our book, that phrase means different things to different people, so we will stick with CFA* to avoid confusion. Notice that we could simplify our CFA* calculation a bit by writing it as: The term EBIT × (1 − TC) is just what net income would have been if the firm had used no debt, and the sum of the first two terms is our bottom-up definition of operating cash flow from Chapter 10. At this point, if the firm is growing steadily, we can value it using our growing perpetuity formula (as we did earlier in this chapter). For example, suppose you project CFA* for the coming year as million. You think this amount will grow indefinitely at g = 5 percent per year. You’ve estimated the firm’s WACC to be 9 percent, so the value of the firm today (V0) is: In sum, valuing a firm is no different from valuing a project, except for the fact that we have to adjust the taxes to remove the effect of any debt financing. We can also consider the impact of nonconstant growth (as we did in an earlier chapter on stock valuation using the dividend growth model). In this case, we assume that constant growth begins at Time t in the future. In that case, we can write the value of the firm today as: Here, Vt is value of the firm at Time t, which we again calculate using the growing perpetuity formula: Flotation Costs and the Average Cost of Capital Sometimes it is suggested that the firm’s WACC should be adjusted upward to reflect flotation costs. This is really not the best approach because, once again, the required return on an investment depends on the risk of the investment, not the source of the funds. This is not to say that flotation costs should be ignored. Because these costs arise as a consequence of the decision to undertake a project, they are relevant cash flows. We therefore briefly discuss how to include them in project analysis. THE BASIC APPROACH Impact of Flotation Costs on Expansion All-Equity Firm: In the case of Spatt Company, an all-equity firm, the cost of equity is 20%, and since the firm is entirely financed by equity, the weighted average cost of capital (WACC) is the same as the cost of equity. Flotation Costs: When Spatt decides to expand by raising $100 million, flotation costs (fees incurred during the issuance of new stock) are 10% of the amount raised. Therefore, Spatt cannot simply issue $100 million of stock because it would lose 10% in flotation fees. To account for this, Spatt needs to raise $111.11 million to cover the $100 million expansion and the 10% flotation cost. Weighted Average Flotation Costs for Debt and Equity  Debt and Equity Mix: If a firm uses both debt and equity in its capital structure, the calculation becomes slightly more complex. In Spatt's case, if the target capital structure is 60% equity and 40% debt, and the flotation costs for equity and debt are different (10% for equity, 5% for debt), a weighted average flotation cost must be calculated.  Weighted Average Flotation Cost (fA): This is computed by weighting the flotation costs of equity and debt according to their proportion in the capital structure:  INTERNAL EQUITY AND FLOTATION COSTS Our discussion of flotation costs to this point implicitly assumes that firms always have to raise the capital needed for new investments. In reality, most firms rarely sell equity at all. Instead, their internally generated cash flow is sufficient to cover the equity portion of their capital spending. Only the debt portion must be raised externally. The use of internal equity doesn’t change our approach. However, we now assign a value of zero to the flotation cost of equity because there is no such cost. In our Tripleday example, the weighted average flotation cost would therefore be: