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Learning objectives of this chapter include: Know how to determine a firm’s cost of equity capital, know how to determine a firm’s cost of debt, know how to determine a firm’s overall cost of capital, understand pitfalls of overall cost of capital and how to manage them, understand the impact of an imputation tax system.
Cost of capital Chapter 12 Key concepts and skills • Know how to determine a firm’s cost of equity capital • Know how to determine a firm’s cost of debt • Know how to determine a firm’s overall cost of capital • Understand pitfalls of overall cost of capital and how to manage them Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-2 Chapter outline • • • • • The cost of capital: Some preliminaries The cost of equity The costs of debt and preferred stock The weighted average cost of capital Divisional and project costs of capital Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-3 Why cost of capital is important? • We know that the return earned on assets depends on the risk of those assets • The return to an investor is the same as the cost to the company • Our cost of capital provides us with an indication of how the market views the risk of our assets • Knowing our cost of capital can also help us determine our required return for capital budgeting projects Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-4 Required return • 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 NPV 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 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-5 Cost of equity • The cost of equity is the return required by equity investors given the risk of the cash flows from the firm • There are two main methods for determining the cost of equity: Dividend growth model SML or CAPM Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-6 Dividend growth model method • Start with the dividend growth model formula and rearrange to solve for R E P0 RE D1 RE g D1 P0 g Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-7 Dividend growth model method—Example • Your company is expected to pay a dividend of $4.40 per share next year (D1) • Dividends have grown at a steady rate of 5.1% per year and the market expects that to continue (g) • The current stock price is $50 (P0) • What is the cost of equity? RE 4.40 50 051 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 139 12-8 Estimating the dividend growth rate—Example • One method for estimating the growth rate is to use the historical average Year Dividend % change 2003 1.23 (1.30 – 1.23) / 1.23 = 5.7% 2004 1.30 (1.36 – 1.30) / 1.30 = 4.6% 2005 1.36 (1.43 – 1.36) / 1.36 = 5.1% 2006 1.43 (1.50 – 1.43) / 1.43 = 4.9% 2007 1.50 Average = (5.7 + 4.6 + 5.1 + 4.9) / = 5.1% Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-9 Advantages and disadvantages of dividend growth model method • Advantage—easy to understand and use • Disadvantages – Only applicable to companies currently paying dividends – Not applicable if dividends aren’t growing at a reasonably constant rate – Extremely sensitive to the estimated growth rate – Does not explicitly consider risk Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-10 Cost of equity—Domino’s Pizza (cont.) Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-33 Cost of equity—Domino’s Pizza (cont.) Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-34 Cost of equity—Domino’s Pizza (cont.) • Cost of equity using CAPM – Assume equity market risk premium= 6% – Risk-free rate= 5.25% (Australian government bond rate) – Beta = 0.85 (from yahoo finance) – RE=0.0525+ 0.85(0.06)=0.1035 or 10.35% • Cost of equity using dividend growth model – Growth = 13.8% (using key statistics from yahoo finance) – Last dividend = $0.124 – Current share price = $ 5.07 – RE= 0.124(1+0.138)/5.07 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-35 Cost of debt—Domino’s Pizza • The following is extracted from Domino’s Pizza’s corporate website: • Overall weighted average debt cost Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-36 WACC—Domino’s Pizza • Weights calculated using the total market value – Total market value = $366.88 million – Equity = $346.18 million – Debt = $20.7 million • Weights – WE = 0.94; WD = 0.06 • WACC – 0.94(0.1315)+0.06(0.082)(1-0.3) = 12.71% Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-37 Divisional and project costs of capital • Using the WACC as our discount rate is only appropriate for projects that are the same risk level as the firm’s current operations • If we are looking at a project that is NOT the same risk level as the firm, we need to determine the appropriate discount rate for that project • Divisions also often require separate discount rates Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-38 Risk-adjusted WACC • A firm’s WACC reflects the risk of an average project undertaken by the firm – ‘Average’ risk = the firm’s current operations • Different divisions/projects may have different risks – The division’s or project’s WACC should be adjusted to reflect the appropriate risk and capital structure Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-39 Using WACC for all projects • What would happen if we used the WACC for all projects, regardless of risk? • Assume the WACC = 15% Decision Project A B C IRR 17% 18% 12% WACC=15% Accept Accept Reject Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-40 Using WACC for all projects (cont.) • Assume the WACC = 15% • Adjusting for risk changes the decisions Required Project Return A 20% B 15% C 10% IRR 17% 18% 12% Decision WACC=15% Risk Adj Accept Reject Accept Accept Reject Accept Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-41 Divisional risk and the cost of capital—Figure 12.1 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-42 Pure play approach • Find one or more companies that specialise in the product or service being considered • Compute the beta for each company • Take an average • Use that beta along with the CAPM to find the appropriate return for a project of that risk • Pure-play companies are difficult to find Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-43 Subjective approach • Consider the project’s 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 shouldn’t and reject projects you should accept, but your error rate should be lower than when not considering differential risk at all Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-44 Subjective approach— Example Risk level Discount rate Very low risk WACC – 8% Low risk WACC – 3% Same risk as firm WACC High risk WACC + 5% Very high risk WACC + 10% Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-45 Quick quiz • What are the two approaches for computing the cost of equity? • How you compute the cost of debt and the after-tax cost of debt? • How you compute the capital structure weights required for the WACC? • What is the WACC? • What happens if we use the WACC for the discount rate for all projects? • What are two methods that can be used to compute the appropriate discount rate when WACC isn’t appropriate? Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-46 Chapter 12 END 12-46 ... determine a firm’s cost of equity capital • Know how to determine a firm’s cost of debt • Know how to determine a firm’s overall cost of capital • Understand pitfalls of overall cost of capital and... equity The costs of debt and preferred stock The weighted average cost of capital Divisional and project costs of capital Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate. .. PPTs t/a Essentials of Corporate Finance 2e by Ross et al Slides prepared by David E Allen and Abhay K Singh 12-2 Chapter outline • • • • • The cost of capital: Some preliminaries The cost of equity