Chapter 12 Cost of Capital

The required return for an asset is a function of the risk of the asset and the return to the investor is the same as the cost to the company. The firms cost of capital provides an indication of how the market views the risk of the asset. Knowing the cost of capital helps the financial manager determine the required return for capital projects. The required return is the same as the appropriate discount rate and is based on the risk of the cash flows. We need to know the required return for an investment before we can compute the NP and make a decision about whether or not to take the investment. We need to earn at least the required return to compensate our investors for the financing they have provided.

Weighted !verage "ost of "apital #W!""$

%iven the following information& what is the W!"" for the following firm' (ebt) Preferred 3tock) "ommon 3tock) 7arket) *&+++ bonds with a par value of ,-&+++ and a quoted price of --../0. The bonds have coupon rate of 1 percent and .2 years to maturity. .+&+++ shares of 4.0 percent preferred selling at a price of ,/0. 5++&+++ shares of stock selling at a market price of ,52. The beta of the stock is +.*. The stock just paid a dividend of ,..-+ per share and the dividends are e6pected to grow at / percent per year indefinitely. The e6pected return on the market is -5 percent and the risk8free rate is 4.0 percent. The company is in the 42 percent ta6 bracket.

-.
(ebt

"omponent "osts

-&-./.0+ =

1+ PVIFA ( .2 )( . ) & YTM . .

+-&+++ PVIF ( .2 )( . ) & YTM .

N P Pmt ?

#.$#.2$ 9 0/ 8,-&-./.0+ 40 -&+++

"pt : 4.+.2; 9 <T7=. > <T7 9 /.+/;

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Preferred 3tock
kp 9
(4.0+ 9 9 .+042 or 0.42 ; P+ /0

Aquity)
The cost of equity is the return required by equity investors given the risk of the cash flows from the firm. ke 9 Bf C DA#B7$ E BfF 9 4.0 C +.*D-5 E 4.0F 9 -..*0; Advantages of the CAPM Explicitly adjusts for systematic risk Applica le to all companies! as long as "e can compute eta #isadvantages of the CAPM $ave to estimate the expected market risk premium! "hich does vary over time $ave to estimate eta! "hich also varies over time %e are relying on the past to predict the future! "hich is not al"ays relia le ke 9
(..-+#-.+/$ Cg9 C .+/ 9 .-+/5 or -+./5; P+ 52

Advantage of &ordon &ro"th Model Easy to understand and use #isadvantages of &ordon &ro"th Model 'nly applica le to companies currently paying dividends (ot applica le if dividends aren)t gro"ing at a reasona ly constant rate Extremely sensitive to the estimated gro"th rate an increase in g of 1* increases the cost of e+uity y 1* #oes not explicitly consider risk ke 9
-..*0; +-+./5; 9 --.2+; .

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..

"omponent Weights
wd 9 +.44wp 9 +.+5. we 9 +./.1

(ebt) #*&+++$#,-&-./.0+$ 9 ,-+&-42&0+ + P3) A) #.+&+++$#,/0$ 9 #5++&+++$#,52$ 9 ,-&4++&+++ ,-*&.++&++ + ,4+&/42&0+ +

4.

W!""

W!"" 9 w(B(#-8T"$ C wPBP C wABA W!"" 9 #+.44-$#/.+/;$#- E +.42$ C #+.+5.$#0.42$ C #+./.1$#--.2+$ 9 2.2/;

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The Perkins "ompany has employed you to analyGe a capital project. :t has given you the following information) Bond Coupon Rate Price Quote Maturity Number of Bonds Outstanding 1 6.75 95.5 22 35,000

2 7.25 110 20 45,000 The bonds make semiannual interest payments and the marginal ta6 rate is 5+ percent. Perkins e6pects the ne6t dividend #(-$ to be ,+.50 and its common stock is currently selling for ,0./.0 per share. The e6pected growth rate in earnings and dividends is a constant 0;. Perkins has a beta of -.4& the risk8free rate is 4 percent& and the e6pected market return is -..0 percent. Perkins has .0&+++&+++ shares of common stock outstanding. To complete the analysis& the NP and :BB need to be calculated the project. The initial investment is ,-... million. The net cash flows are ,/ million for years one through four and ,2 million for year five. 3hould Perkins accept this project'

-.
(ebt

"omponent "osts

Hond *00.++ = /1.0 PVIFA YTM . ( .. ) & . . +-&+++ PVIF YTM . ( .. ) & .

N P Pmt ? Hond .
-&-++.++ =

#.$#..$ 9 55 8,*00.++ 44.10 -&+++

"pt : 4.02; 9 <T7=. > <T7 9 1.-/;

1..0 PVIFA YTM . ( .+ ) & . .

+-&+++ PVIF YTM . ( .+ ) & .

N P Pmt

#.$#.+$ 9 5+ 8,-&-++.++ 4/..0

"pt : 4.-2; 9 <T7=. > <T7 9 /.4/;

? -&+++ Weighted cost of debt

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Hond -)

#40&+++$#,*00.++$ 9 ,44&5.0&++ +

wd- 9 +.5+4wd. 9 +.0*/*

Hond .) #50&+++$#,-&-++.++$ 9 ,5*&0++&++ + ,2.&*.0&++ + B( 9 w(-B(- C w(.B(. B( 9 #+.5+4-$#1.-/;$ C #+.0*/*$#/.4/;$ 9 /./2;

Aquity
ke 9 Bf C DA#B7$ E BfF 9 4.+ C -.4D-..0 E 4.+F 9 -0.40; ke 9 ke 9
(+.50 Cg9 C .+0 9 .-4++ or -4.++; P+ 0./.0
-0.40; +-4.++; 9 -5.-10; .

..
(ebt) A)

"omponent Weights
,2.&*.0&+++ #.0&+++&+++$#,0./.0$ 9 ,-5+&/.0&++ + ,..4&00+&++ + wd 9 +.41+* we 9 +./.*-

4.

W!""

W!"" 9 w(B(#-8T"$ C wPBP C wABA W!"" 9 #+.41+*$#/./2;$#- E +.5+$ C #+./.*-$#-5.-10$ 9 -+.5+5; "?+ "?"?. : 8-... /.+ 2.+ -+.5+5 ?- 5 ?. -

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; "pt NP "pt :BB ,--.04 5-.2+;

!djusting the cost of capital

W!"" and "!P7
(raw graph

(ivisional "ost of "apital

Ising the W!"" as our discount rate is only appropriate for projects that are the same risk as the firmJs current operations :f we are looking at a project that is NKT the same risk as the firm& then we need to determine the appropriate discount rate for that project (ivisions also often require separate discount rates Transco %enco Begulated& @ow Bisk Inregulated& Ligh Bisk

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3ubjective !pproach
"onsider the projectJs risk relative to the firm overall :f the project is more risky than the firm& use a discount rate greater than the W!"" :f the project is less risky than the firm& use a discount rate less than the W!"" <ou may still accept projects that you shouldnJt and reject projects you should accept& but your error rate should be lower than not considering differential risk at all

A6ample
Bisk @evel ery @ow Bisk @ow Bisk 3ame Bisk as ?irm Ligh Bisk ery Ligh Bisk (iscount Bate W!"" E 2; W!"" E 4; W!"" W!"" C 0; W!"" C -+;

Pure Play !pproach

?ind one or more companies that specialiGe in the product or service that we are considering "ompute the beta for each company Take an average Ise that beta along with the "!P7 to find the appropriate return for a project of that risk Kften difficult to find pure play companies

Heta) 3hould you use an industry beta'

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