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WACC
10 - 1
Retained Earnings
Cost of a source of capital for the company would be the investors required return on that investment.
Cal State - East Bay
10- 2
Intuition
NPV CFFA0
1 r
CFFA1
1
1 r
CFFAm
m
The required return r must 1. compensate our investors (common, preferred, and bonds) for the risks they bear 2. take into account what fraction of the funding is coming from each type of investor 3. take taxes into account
Cal State - East Bay
10- 3
10- 4
Required Return
The required return is based on the risk of the cash flows With the required return we can compute the NPV We need to earn at least the required return to compensate our investors for the financing they have provided
10- 5
Initial Assumptions
1. The cash flows of the project are of similar risk to those of the existing firm 2. The project will use a similar mix of financing as the existing firm
10- 6
Why is the cost of internal equity from reinvested earnings cheaper than the cost of issuing new common stock?
1. When a company issues new common stock they also have to pay flotation costs to the underwriter. 2. Issuing new common stock may send a negative signal to the capital markets, which may depress stock price.
10- 8
Cost of Equity
The return required by common stockholders to invest in our project given the riskiness of project cash flows. Two methods Dividend growth model
SML or CAPM
10- 9
What are the two ways that companies can raise common equity?
Directly, by issuing new shares of common stock. Indirectly, by reinvesting earnings that are not paid out as dividends (i.e., retaining earnings).
10- 10
RE = RE =
2. Using DCF:
You are estimating the cost of retained earnings for Jax Liquor. The current stock price is $40 and the next expected dividend is $2.00. The companys dividends are expected to grow at a constant annual rate of 6%.
D0 1 g D1 rs g g P P 0 0
$2.00 0.06 $40 .00
0.11
Cal State - East Bay
10- 12
10- 13
Percent Change
(1.30 1.23) / 1.23 = 5.7% (1.36 1.30) / 1.30 = 4.6% (1.43 1.36) / 1.36 = 5.1% (1.50 1.43) / 1.43 = 4.9%
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RE R f E ( E ( RM ) R f )
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Advantages
Disadvantages
Have to estimate the expected market risk premium Have to estimate beta We are relying on the past to predict the future, which is not always reliable
10- 20
1. Using CAPM
You are trying to estimate the cost of retained earnings for Xenex CO. A 10-year treasury bond is currently yielding 7%. You estimate that the companys beta is 1.14 and that the required return on the market is 12%. The cost of retained earnings using CAPM would be:
rs 0.07 1.14 (0.12 0.07 ) 0.127 12 .7%
10- 21
Cost of Debt
The cost of debt is the required return on our companys debt We usually focus on the cost of long-term debt or bonds Estimated by computing the yield-tomaturity on the existing debt We may also use estimates of current rates based on the bond rating we expect when we issue new debt The cost of debt is NOT the coupon rate
Cal State - East Bay
10- 22
Cost of Debt
Method 1: Ask an investment banker what the coupon rate would be on new debt. Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating. Method 3: Find the yield on the companys debt, if it has any.
10- 23
Cost of Debt
Assume that a firm has an outstanding 30year semi-annual coupon bond with a face value of $1,000 and an annual coupon rate of 14%. The bond is selling at par. If the company issues new bonds, a flotation cost of 5% would be incurred. The firms combined marginal federal and state tax rate is 40%. What is the cost of debt?
Cal State - East Bay
10- 24
Cost of Debt
First calculate the YTM, taking into account that the firm only receives (1-0.05)$1,000 = 950 per bond issued: 0 1 2 60
i=?
-950
70
...
1,000 70 + 1,000
INPUTS OUTPUT
Cal State - East Bay
60
N
-950
I/YR
PV
70
PMT
1,000
FV
7.37% x 2 = rd = 14.74%
10- 25
Cost of Debt
Interest is tax deductible, so the after tax (AT) cost of debt is:
rd AT = rd BT(1 - T) = 14.74%(1 - 0.40) = 8.84%.
10- 26
D0 (1 g ) Rp g P0 D Rp P0
Cal State - East Bay
10- 27
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Example:
rps = 9% rd = 10% T = 40%
rps, AT = rps - rps (1 - 0.7)(T) = 9% - 9%(0.3)(0.4) = 7.92% rd, AT = 10% - 10%(0.4) = 6.00% A-T Risk Premium on Preferred = 1.92%
10- 31
Average the returns required to attract different types of investors to get a single discount rate. This average is the overall required return on our assets, based on the markets perception of the risk of those assets The weights are determined by how much of each type of financing that we use
Cal State - East Bay
10- 32
Dividends are not tax deductible, so there is no tax impact on the cost of equity WACC = wERE + wDRD(1-TC) + wPRP
Cal State - East Bay
10- 34
Example:
Current (Optimal) Capital Structure: Debt: 25% Pref St: 15% Com St:60% NI = $17,142.86 Div pay-out ratio: 30%; tax rate = 40% D0 = $3.60; P0 = $60; g=9% rRF = 11%; rM = 14%; beta = 1.51 Flotation costs on new common stock(F) = 10% Par value of new preferred stock = $100 Dividend on new preferred stock = $11 Flotation Cost on new preferred stock = $5 per share Before-tax required return on new debt = 12%
Cal State - East Bay
10- 35
Method 1: rs=D1/P0+g = 3.60(1.09)/60+0.09 = 0.1554 Method 2: rs= rRF +(rM rRF) = 0.11+1.51(.14-.11) = .1553
re = D1/(P-F)+g = 3.60(1.09)/(60(1-0.1))+0.09 = 0.1627
10- 36
How much new capital could be raised before the firm needs to sell new equity? Retained Earnings available:
NI(1-div payout ratio) = 17142.86(1-.30) = 12,000
10- 37
WACC
Using retained earnings:
WACC = 0.25(0.12)(1-0.4)+0.15(0.1158)+0.60(0.1554) = 0.1286 = 12.86%
10- 38
Graphically:
WACC
13.30% 12.86%
$20,000
Cal State - East Bay
$ of new capital
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WACC wE RE wD RD 1 T wP RP
NPV CFFA0 CFFA1 CFFAm
1 WACC
1 WACC
IRR ?
Cal State - East Bay
10- 42
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FIGURE 15.1
10- 45
Subjective Approach
Consider the projects risk relative to the firm overall If the project is more risky than the firm, use a discount rate greater than the WACC If the project is less risky than the firm, use a discount rate less than the WACC You may still accept projects that you shouldnt and reject projects you should accept, but your error rate should be lower than not considering differential risk at all
Cal State - East Bay
10- 47
48
FIGURE 15.2
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