Computing Cost of Capital PDF

COMPUTING COST OF CAPITAL Cost of Debt Cost of Preference Shares Cost of Ordinary Shares Weighted Average Cost of Capital  A. COST OF DEBT The cost of debt is the minimum rate of return required by suppliers of debt. The before-...

COMPUTING COST OF CAPITAL Cost of Debt Cost of Preference Shares Cost of Ordinary Shares Weighted Average Cost of Capital  A. COST OF DEBT The cost of debt is the minimum rate of return required by suppliers of debt. The before-tax cost of debt is the interest rate a firm must pay on its new debt. The after-tax cost of debt should be used to calculate the WACC (Weighted Average Cost of Capital). ❑This is the interest rate on new debt less the tax savings that result because interest is tax deductible. ❑After-tax cost of debt = Interest rate (1-Tax rate) ❑In effect, the government pays part of the cost of debt because interest is tax deductible.  EXAMPLE If XYZ Corporation can borrow at an interest rate of 12% and its marginal corporate tax rate is 35%, its after-tax cost of debt will be 7.8%.  COMPUTING THE COST OF A NEW BOND ISSUE 1. Determine the net proceeds from the sale of each bond. Net Proceeds of a Bond Sale = Market Price - Flotation Costs 2. Compute the before-tax cost of the bond is the rate of return that equates the present value of the future interest payments and principal payment with the net proceeds from the sale of the bond using the equation. NPd = 1 (PVIFAkd,n) + Pn (PVIFkd,n ) or + Par Value - Net Proceeds Annual Interest Term of the bonds Par Value + Net Proceeds 2 3. Compute the after-tax cost of debt kdt = kd (1 – T) where:  EXAMPLE Prime Pipe Company plans to issue 25-year bonds with a face value of P4,000,000. Each bond has a par value of P1,000 and carries a coupon rate of 9.5 percent. However, the bond is expected to sell for 98 percent of par value. The flotation costs are estimated to be approximately P26 per bond and the firm's marginal tax rate is 34 percent. (Assume that interest payments are made annually.) Required: Management wants to calculate the (a)net proceeds per bond, 954 (b)the before-tax cost of this bond issue, and 9.91% (c)the after-tax cost of the bond issue's flotation costs. 6.54%  B. COST OF PREFFERED SHARES if the preferred shares have fixed dividend payments and no stated maturity dates, the component cost of new preferred share is computed as follows: Where: Dp = Annual dividend per share on preferred share NPp = Net proceeds from the sale of preferred share, (Market price less flotation costs)  EXAMPLE Prime Pipe Company plans to sell preferred share for its par value of P25.00 per share. The issue is expected to pay quarterly dividends of P0.60 per share and to have flotation costs of 3 percent of the par value. The cost of preferred share is:  C. COST OF ORDINARY SHARES Ordinary equity share does not represent a contractual obligation to make specific payments thus making it more difficult to measure its costs than the cost of bonds or preferred share. Business firms raise equity capital externally through the sale of new ordinary equity shares and internally through retained earnings. The costs of new ordinary equity share and retained earnings are similar but not equal. No adjustment is made for flotation costs in determining either the cost of existing ordinary equity share or the cost of retained earnings. The cost of new ordinary equity share is higher than the cost of retained earnings because of the flotation costs involved in selling new ordinary equity share which reduce the net proceeds to the firm. Thus, firms will use the lower-cost retained earnings before they issue new ordinary equity share.  C. COST OF ORDINARY SHARES A. COST OF EQUITY 1. CAPM Approach 2. Bond Yield Plus Risk Premium Approach 3. Dividend Yield Plus Growth Rate Approach 4. Discounted Cash Flow (DCF) Approach 5. Earnings-Price Ratio Method B. COST OF NEW ORDINARY EQUITY SHARES 1. Constant Growth Model C. COST OF RETAINED EARNINGS  EXAMPLE CAPM APPROACH ABC Company's ordinary equity shares sell for P32.75 per share. ABC expects to set their next annual dividend at P1.54 per share. If ABC expects future dividends to grow by 6% per year, indefinitely, the current- risk-free rate is 3%, the expected return on the market is 9%, and the stock has a beta of 1.3, what should the firm's cost of equity be? 10.80%  B O N D YI E L D P L US R I S K P R E M IUM AP P ROACH EXAMPLE Prime Pipe Company's long- term bond rate is 9.5 percent. The firm's management estimates that its cost of equity The base rate is often the rate on Treasury bonds should require a 3 percentage or the rate on the firm's own bonds. point risk premium above the The risk premium on a firm's own stock over its own bonds is based on a judgmental estimate but cost of its own bonds. empirical studies suggest that it ranges between 3 to 5 percentage points above the base rate. 12.50% However, risk premiums are not stable over time, hence the estimated value of ks is also judgmental.  DIVIDEND YIELD PLUS EXAMPLE GROWTH RATE APPROACH Suppose that Whaller Corporation has a beta of 80. The market risk premium is 6%, and the risk-free rate is 6%. Whaller's last dividend was P1.20 per share and the dividend is expected to grow at 8% indefinitely The stock currently sells for P45 per share.  DISCOUNTED CASH FLOW EXAMPLE (DCF) APPROACH Zeta stock sells for P23.06, its next expected dividend is The method of estimating the cost of P1.25, and analysts expect its equity called the discounted cash flow growth rate to be 8.3%. or DCF method considers not only the dividend yield (Dl / Po), but also a capital gain (g) for a total expected 13.70% return of Ks.  EARNINGS -PRICE RATIO EXAMPLE METHOD Prime Pipe Company had earnings per share for the past year of P6.50, and the firm's ordinary equity share is The earnings-price ratio method is a simplistic currently priced at P45.00. technique used to estimate the cost of ordinary equity, which is based on the inverse of the firm's price-earnings ratio. 14.44% The earnings-price ratio is easy to compute because it is based on readily available information, but there is little economic logic to support the use of the earnings-price ratio to measure the cost of ordinary equity.  B. COST OF NEW ORDINARY EQUITY SHARES CONSTANT GROWTH MODEL assumes that dividends grow perpetually at a constant annual rate, g. Estimates of g are usually based on historical growth rates, if earnings and dividend growth rates have been stable in the past, or on analysts’ forecasts.  EXAMPLE Suppose that ABC Company's ordinary Prime Pipe Company's ordinary equity equity shares are selling for P32.75 per share has a current market price of share, and the company expects to set its P45.00 and an expected dividend growth next annual dividend at P1.54 per share. rate of 5%. The firm is expected to pay All future dividends are expected to P3.60 per share in ordinary equity share grow by 6% per year, indefinitely. In dividends during the next year. The sale addition, let's also suppose that ABC of new ordinary equity share involves faces a flotation cost of 20% on new underpricing of P1.00 per share and equity issues. underwriting fee of P0.80 per share. Calculate the flotation-adjusted cost of What is the cost of the new ordinary equity. 11.88% equity share? 13.33%  COST OF RETAINED EARNINGS Retained earnings represent the portion of accumulated after-tax profits that the firm has not distributed to its shareholders and therefore is reinvested in itself. Some have argued that retained earnings should be "cost-free" because they represent money that is "left-over" after dividends are paid. While it is true that no direct costs are associated with retained earnings, this capital still has a cost, an opportunity cost. The managers who work for the shareholders can either pay out earnings in the form of dividend or retain earnings for reinvestment in the business. Therefore, the firm needs to earn at least as much as any earnings retained as the stockholder could earn an alternative investment of comparative risk. The cost of retained earnings is similar to the cost of existing ordinary equity share.  WHEN MUST EXTERNAL EQUITY BE USED? Because of flotation costs, pesos raised by selling new stock must "work harder" than pesos raised by retaining earnings. Moreover, because no flotation costs are involved, retained earnings cost less than new shares. Therefore, firms should utilize retained earnings to the greatest extent possible. However, if a firm has more good investment opportunities than- can be financed with retained earnings plus the debt and preferred share supported by those retained earnings, it may need to issue new ordinary equity or ordinary share. The total amount of capital that can be raised before new shares must be issued is defined as the retained earnings breakpoints and it can be calculated as follows:  EXAMPLE Zeta's addition to retained earnings in 2014 is expected to be P2M, and its target capital structure consists of 40% debt, and 60% ordinary equity. 2,000,000/0.60= 3,333,333  DETERMINATION OF WEIGHTED AVERAGE COST OF CAPITAL Once the specific cost of capital of each long-term financing source is measured, the firm's weighted average cost of capital (WACC), Ka, can be determined. The target proportions of debt, preferred share, and ordinary equity along with the costs of those components are used to calculate the firm's weighted average cost of capital. WACC can be computed as follows:  DETERMINATION OF WEIGHTED AVERAGE COST OF CAPITAL Note that only debt has a tax adjustment factor (I- T). This is because interest on debt is tax deductible but preferred dividends and returns on ordinary equity share (dividends and capital gains) are not. A WACC can be computed for either the firm's existing financing or new financing. The cost of capital acquired by the firm in earlier periods is not relevant for current decision making because it represents a historical or sunk cost. Thus, only the WACC for new financing is generally calculated. WACC is computed by multiplying the specific cost of each type of capital by its proportion (weight) in the firm's capital structure and summing the weighted values.  DETERMINATION OF WEIGHTED AVERAGE COST OF CAPITAL There two major schemes in computing the weighted average cost of capital, namely. A. Historical Weights i. Book value weights ii. Market value weights B. Target Weights  A. HISTORICAL WEIGHTS BOOK VALUE WEIGHTS MARKET VALUE WEIGHTS measure the actual proportion of measure the actual proportion of each each type of permanent capital in the type of permanent capital in the firm's firm's structure based on accounting structure at current market prices. This values shown on the firm's balance is considered more superior to book sheet. value weights because they provide This basis however may misstate the estimates of investors' required rates of WACC because they ignore the return. changing market values of bonds and However, market value weights are less equity over time, and may not provide stable than book value weights in a useful cost of capital for evaluating computing cost of capital because current strategies. market prices change frequently. WACC DETERMINATION USING BOOK VALUE WEIGHTS WACC DETERMINATION USING MARKET VALUE WEIGHTS SOLUTION  B. TARGET WEIGHTS Target weights are based on a firm's desired capital structure. Firms using target weights establish these proportions on the basis of optimal capital structure they wish to attain. Thus, the firm raises additional funds so as to remain constantly on target with its optimal capital structure. The preferable approach though is to use target weight based on market values rather than historical weights. Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below. The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%. ❑ What is the best estimate of the after-tax cost of debt? ❑ If the project you intend to pursue has a return of 15%, will you pursue the project? ❑ If the project you intend to pursue has a range of 10%-12% potential return, will you pursue the project?