A B C D E F G H

1 Ch 9 Mini Case 3/19/2001

2
3 Chapter 9. Mini Case
4
5 Situation
6 During the last few years, Harry Davis Industries has been too constrained by the high cost of capital to make many
7 capital investments. Recently, though, capital costs have been declining, and the company has decided to look
8 seriously at a major expansion program that had been proposed by the marketing department. Assume that you
9 are an assistant to Leigh Jones, the financial vice-president. Your first task is to estimate Harry Davis's cost of capital.
10 Jones has provided data that she believes is relevant to your task.
11 (1) The firm's tax rate is 40%
12 (2) The current price of Harry Davis' 12 percent coupon, semiannual payment, noncallable bonds with 15 years remaining
13 to maturity is $1,153.72. Harry Davis does not use short-term interest-bearing debt on a permanent basis. New bonds
14 would be privately placed with no flotation costs.
15 (3) The current price of the firm's 10 percent, $100 par value, quarterly dividend, perpetual preferred stock is $113.10
16 Harry Davis would incur a flotation cost of $2.00 per share on a new issue.
17 (4) Harry Davis' common stock is currently selling at $50 per share. Its last dividend (Do) was $4.19, and dividends are
18 expected to grow at a constant rate of 5% in the foreseeable future. Harry Davis' beta is 1.2, the yield on T-bonds is
19 7 percent, and the market risk premium is estimated to be 6 percent. For the bond-yield-risk-premium approach,
20 the firm uses a 4 percentage point risk premium.
21 (5) Harry Davis' target capital structure is 30 percent long-term debt, 10 percent preferred stock, and 60 percent common
22 equity.
23
24 Sources of Capital
25 Long-term debt
26 Preferred Stock
27 Common Equity
28
29 The cost of capital is the weighted average cost of the debt, preferred stock, and common equity that the firm uses
30 to finance its assets, or its WACC. There is an overall, or corporate, WACC which reflects the average riskiness
31 of all the firm's assets. However, since different assets may have more or less risk than the average, the overall
32 WACC must be adjusted up or down to reflect the riskiness of different proposed capital budgeting projects.
33
34 Tax effects associated with financing either in capital budgeting cash flows or in costs of capital. Most firms
35 incorporate tax effects in the cost of capital, therefore focus on after-tax costs. After-tax costs only effect the cost
36 of debt. This is due to interest on debt being tax deductible.
37
38 Embedded or Marginal Costs
39 The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should
40 focus on marginal costs.
41
42 COST OF DEBT, kd
43 A 15-year, 12% semiannual bond sells for $1,153.72. What is kd?
44
45 0 1 2 30
46
47 N 30
48 PV 1,153.72
49 PMT 60
50 FV 1000 kd = 10%
51
52
53 The relevant cost of debt is the after-tax cost of new debt, taking account of the tax deductibility of interest. The
54 after-tax calculated by multiplying the interest rate (or the before-tax cost of debt) times one minus the tax rate.
55
56 PROBLEM
57 Find the after-tax cost of debt for a company that pays 10% interest on debt and is subject to a 40% marginal tax
58 rate.
 A B C D E F G H
59
60 B-T kd 10%
61 Tax rate 40%
62
63 A-T kd = (1-Tax rate) x (B-T kd)
64 A-T kd = 60% x 10%
65
66 A-T kd = 6.0%
67
68 COST OF PREFERRED STOCK, kp
69
70 The cost of preferred stock is simply the preferred dividend divided by the price the company will receive if it
71 issues new preferred stock. No tax adjustment is necessary, as preferred dividends are not tax deductible.
72
73 PROBLEM
74 What is the cost of preferred stock for a company that pays a preferred dividend of $10 per share if the company
75 could sell new preferred for $113.10 per share, with a flotation cost of $2.00?
76
77 Pref. Dividend $10.00
78 Pref. Price $113.50
79 Flotation costs $2.00
80
81 kps = Pref. Dividend ÷ (Pref. Price - Flotation Costs)
82 kps = $10.00 ÷ $113.50 $2.00
83
84 kps = 9.0%
85
86 Preferred stock carries a higher risk to investor than debt. Companies are not required to pay preferred dividends
87 Although, firms typically want to pay preferred dividends. Otherwise, they cannot pay common dividends, there will
88 be difficulty raising additional funds, and preferred stockholders main gain control of the firm.
89
90 Corporations own most preferred stock, because 70% of preferred dividends are non-taxable to corporations.
91 Therefore, preferred stock often has a lower before tax yield than the before tax yield on debt. But, the after tax
92 costs to the issuer are higher on preferred stock than debt. This is consistent with the higher risks of preferred
93 stock.
94 kps 9%
95 kd 10%
96 T 40%
97
98 A-T kps = kps - kps x (1-.7) *T
99 A-T kps = 9% - 9% x 0.12
100
101 A-T kps = 7.92%
102
103 A-T kd = (1-Tax rate) x (B-T kd)
104 A-T kd = 60% x 10%
105
106 A-T kd = 6.0%
107
108 A-T Risk Premium on Preferred 1.92%
109
110
111
112 COST OF EQUITY (INTERNAL), ks
113
There are two sources of equity capital, internal equity and external equity. External equity is raised when the
114 firm issues new stock. Mature firms (other than utilities) rarely issue new equity, for two main reasons. First,
there are considerable commissions and fees, called flotation costs, when a firm issues new equity. Second,
investors perceive issuing equity as a negative signal with respect to the true value of the company's stock; i.e.,
managers know best the company's future prospects, and they are most likely to issue new stock when they think
the current stock price is higher than the true value of the stock. We explain how to incorporate flotation costs
later in this spreadsheet.
 There are two sources of equity capital, internal equity and external equity. External equity is raised when the
A new stock. Mature
firm issues B C than utilities)Drarely issue newEequity, for two F
firms (other G
main reasons. First, H
115 there are considerable commissions and fees, called flotation costs, when a firm issues new equity. Second,
investors perceive issuing equity as a negative signal with respect to the true value of the company's stock; i.e.,
116 managers know best the company's future prospects, and they are most likely to issue new stock when they think
the current stock price is higher than the true value of the stock. We explain how to incorporate flotation costs
117 later in this spreadsheet.

118
119
Firms raise internal equity when they choose to reinvest net income rather than pay it out as dividends. The cost
120 of this internal equity is simply an opportunity cost equal to the return investors could have earned if they had
received dividends and used the dividends to purchase stock in the company. This is the expected return on the
121 firm's stock, ks.
122
123
Several procedures frequently are used to find the cost of equity. These include the CAPM approach (described
124 in Chapter 2), the DCF approach (described in Chapter 5), and a bond-yield-plus-risk-premium approach.
125
126 The CAPM Approach
127
128 ks = risk-free rate + (Market risk premium) (Beta)
129 ks = krf + (RPm) bi (Note: RPM is the expected return on the market minus the risk-free rate.)
130
131
132 PROBLEM
133 Assuming the risk-free rate (i.e., the current yield on a long-term Treasury bond) equals 7%, the expected market
134 return is 13%, and the firm's beta is 1.2, what is the company's cost of equity from internal funds?
135
136
Risk-free rate 7%
137 Expected market return 13%
138 Beta 1.2
139
140 ks = krf + (RPm) (bi)
141 ks = 7.0% + 6.0% 1.2
142 ks = 7.0% + 7.2%
143 ks = 14.2%
144
145
146 THE DISCOUNTED CASH FLOW APPROACH
147
148 The simplest DCF model assumes that growth is expected to remain constant, and in this case: ks = D1/P0 + g.
149
150 The next expected dividend is easy to estimate, and the stock price can be determined readily. However, it is not
151 easy to determine the marginal investor's expected future growth rate. Three approaches are commonly used: (1)
152 historical growth rates, (2) retention growth model, and (3) analysts' forecasts.
153
154
155 PROBLEM
156 Suppose a firm's stock trades at $50 and its dividend is $4.19. If the expected growth rate is 5%, what is the
157 firm's cost of equity?
158
159 P0 = $50.00
160 D1 = $4.40
161 g= 5%
162
163 ks = D1 ÷ P0 + g
164 ks = $4.40 ÷ $50.00 + 5%
165 ks = 13.8%
 A B C D E F G H
166
167
168
169 2. Retention Growth Model
170
171 Another method for finding the growth is utilizing the sustainable growth rate, found by multiplying the expected
172 future return on equity (ROE) times the expected future retention ratio (i.e., the percent of net income that is not
173 paid out as dividends). This is: g = (Retention rate) (ROE) = (1 - Payout rate) (ROE).
174
175 PROBLEM
176 Suppose a firm's expected ROE is 15% and it pays out 35% of its earnings. What is the firm's sustainable growth
177 rate?
178
179 Find g
180
181 Payout rate = 65%
182 ROE = 15.00%
183
184 g = (1-Payout rate) (ROE)
185 g= 35% 15.00%
186 g= 5.25%
187
188
189
190 APPLICATION OF THE DISCOUNTED CASH FLOW APPROACH WHEN GROWTH IS NOT CONSTANT
191 As we noted earlier, analysts often provide non-constant estimates of future growth. We can use a modification of
192 the discounted cash flow valuation procedure for non-constant growth from Chapter 5 to estimate the cost of
193 equity.
194
195 PROBLEM
196 Suppose the current dividend is $2.00 per share and the current actual price that we observe is $32.00 per share.
197 Analysts forecast growth of 11 percent the first year, 10 percent the second year, 9 percent the third year, 8
198 percent the fourth year, and 7 percent thereafter. Estimate the cost of equity.
199
200 Step 1:
201 Create a time-line showing the expected future dividend payments. These are based on the current dividend and
202 the estimated growth rates.
203
204 Year 0 1 2 3 4 5
205 Growth 11% 10% 9% 8% 7%
206 Dividend 2.16 2.40 2.64 2.87 3.10 3.32
207
208 Step 2:
209 Using the constant growth formula from Chapter 5 to estimate the price at Year 4: P4 = D5 / (ks - g). Notice that D5
210 and g are given in the time-line above, but the estimate for ks is shown below.
211
212 Price at Year 4 = $42.20
213
214 Step 3:
215 Calculate the current price of the stock, based on the estimate of ks below. To do this, find the present value of the
216 price at Year 4, P4, and then find the present value of the dividends from Year 1 through Year 4. Use the cost of
217 equity, ks, shown below, as the discount rate.
218
219 Calculated Current Price $32.00
220
221 Step 4:
222 Use Goal Seek to determine the cost of equity, ks, shown below. Click Tools, Goal Seek and set the value of the
223 Calculated Current Price, cell C295, equal to the actual current stock price of $32 by changing the cost of equity,
ks, in cell B302.
 A B C D E F G H
224 ks, in cell B302.
225
226 ks= 14.9%
227
228 Note that if ks is not equal to 14.9%, then the Calculated Current Price will not be equal to the actual current
229 price of $32. In other words, 14.9% is the only correct value for ks, given the current stock price, the expected
230 future dividends, and the long-term constant growth rate of 7%.
231
232 THE BOND-YIELD-PLUS-RISK-PREMIUM APPROACH
233
 A B C D E F G H
234 This approach consists of adding a judgmental risk premium to the yield on the firm's own long-term debt. It is
logical that a firm with risky, low-rated debt would also have risky, high-cost equity. Historically, we have
235
observed that risk premium for equity is in the range of 3 to 5 percentage points. This method provides a
236 ballpark estimate, and it is generally used as a check on the CAPM and DCF estimates. This method is used
237 primarily in utility rate case hearings.
238
239 PROBLEM
240 If the yield on a company's bonds is 10% and the appropriate equity premium is 4%, what is the cost of equity?
241
242 Equity RP = 4%
243 Bond yield = 10.0%
244
245 ks = (Equity RP) (Bond yield)
246 k s
= 4% 10.0%
247 ks = 14.0%
248
249
250 THE COST OF EQUITY ESTIMATE
251 It is common to use several methods to estimate the cost of equity, and then find the average of these methods.
252
253 Method Cost of Equity
254 CAPM ks = 14.2%
255 Constant growth DCF ks = 13.8%
256 Bond-yield-plus-risk-premium ks = 14.0%
257
258 Average ks= 14.0%
259
260
261 THE WEIGHTED AVERAGE COST OF CAPITAL
262
263 The weighted average cost of capital (WACC) is calculated using the firm's target capital structure together with
264 its after-tax cost of debt, cost of preferred stock, and cost of common equity.
265
266 PROBLEM
267
A firm's target capital structure consists of 30 percent debt, 10 percent preferred stock, and 60 percent common
268 equity. Using the relevant costs calculated previously, what is the firm's weighted average cost of capital?
269
270 wd = 30% kd = 6.0%
271 wp = 10% kp = 9.0% WACC = 11.10%
272 ws = 60% ks = 14.0%
273
274 The WACC is the marginal cost of capital, i.e., the cost of the last unit of capital raised during a given period,
275 usually one year. Note that the WACC will increase if the firm expands so rapidly that it exhausts all of its
276 reinvested earnings for the year and must issue new common stock. We show how to include flotation costs later
277 in this spreadsheet.
278
279 ADJUSTING THE COST OF CAPITAL FOR RISK
280 There is a relationship between the cost of capital and risk--the higher a division's risk, the higher its cost of
281 capital. This relationship is explicitly recognized when we use the CAPM equation, and if we can estimate the betas
282 for individual divisions we can find their risk-adjusted costs of capital. This suggests that the cost of capital can be
283 determined using the systematic risk (beta) associated with a division.
284
285 PROBLEM
286 Find the division's market risk and cost of capital based on the CAPM, given these inputs:
287
288 Risk-free rate 7%
 A B C D E F G H
289 Market risk premium 6.0% ks = 17.2%
290 Beta 1.7
291 Target Debt Ratio 10%
292 kd 12%
293 Tax Rate 40%
294
295 WACC = (wd *kd) x (1-T) + (wc *ks)
296
297 WACC = 1.2% x 60% + 15.5%
298
299 WACC = 16.2% check this
300
301 Division WACC 16.2%
302
303 Company WACC 11.10%
304
305 This indicates that the division's market risk is greater than the firm's average division. Typical projects within
306 this division would be accepted is their returns are above 16.2%.
307
308
309 ADJUSTING THE COST OF CAPITAL FOR FLOTATION COSTS
310
311 Flotation costs are the fees charged by investment bankers plus the accounting an legal expenses associated with
312 the issuance of new securities. A company cannot use the entire proceeds of a new security issuance, because it
313 must use some of the proceeds to pay the flotation costs.
314
315
316 PROBLEM: Flotation Costs and the Cost of New Equity
317 A company's stock sells for $50 and its next dividend is expected to be $4.19, with constant growth of 5%. What is
318 the cost of equity using the DCF model?
319
320 P0 = $50.00
321 D1 = $4.40
322 g= 5%
323
324 ks = D1 ÷ P0 + g
325 ks = $4.40 ÷ $50.00 + 5%
326 ks = 13.8%
327
328 If the firm in the preceding question incurred a flotation cost of 15% for issuing new stock, how much higher is its
329 cost of equity from new common stock?
330
331 Flotation percentage cost (F) = 15%
332 Stock price = $50.00
333
334 Net proceeds after flotation costs = (Stock Price) (1-F)
335 Net proceeds after flotation costs = $50.00 85%
336 Net proceeds after flotation costs = $42.50
337
338 Net proceeds after flotation costs = $42.50
339 D1 = $4.40
340 g= 5%
341
342 ks = D1 ÷ Net Proceeds + g
343 ks = $4.40 ÷ $42.50 + 5%
344 ks = 15.4%
 A B C D E F G H
345
346 Notice that this cost of stock is quite different than the cost of stock without flotation costs. To find the cost of
347 perpetual preferred stock, simply use the procedure above with g=0. If the preferred stock has a fixed maturity,
348 then use the same procedure as for debt, except that the preferred dividend is not tax deductible.
349
350 PROBLEM: Flotation Costs and the Cost of Debt
351
A company can issue a 30-year, $1,000 par value bond with a coupon rate of 10 percent, paid annually. The tax
352
rate is 40%, and the flotation costs are 15% of the value of the issue. Find the after-tax percentage cost of the
353 bond issue.
354
355 Tax rate = 40%
356 Flotation percentage cost (F) = 2%
357 Par value = $1,000
358 Maturity payment = $1,000
359 Pre-tax coupon payment = $100
360
361 First, calculate the after-tax coupon payments and the net proceeds after the flotation costs.
362
363
After-tax coupon payment = (Coupon pmt.) (1-Tax rate)
364 After-tax coupon payment = $100 60%
365 After-tax coupon payment = $60
366
367 Net proceeds after flotation costs = (Par value) (1-F)
368 Net proceeds after flotation costs = $1,000 98%
369 Net proceeds after flotation costs = $980
370
371 Now find the rate that the company pays, based on its net proceeds after flotation costs and its after-tax payments.
372
373 Number of coupon payments = N= 30
374 After-tax coupon payment = PMT= 60
375 Net proceeds after flotation costs = PV= 980
376 Payment of face value at maturity= FV= 1000
377
378 After tax cost of debt = Rate = 6.15% Note: use the Rate function.
379
380 Notice that this after-tax cost of debt is only slightly higher than the after-tax cost of debt for which flotation costs
381 are ignored. Therefore, analysts often ignore the flotation costs of debt.