Managerial Finance

Chapter 14

  • Importance of cost of capital 
    • 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 
    • However, uses of funds (capital budgeting) and sourcing of funds (capital structure) are very separate decisions
    • Provides us with an indication of how the market views the risk of the assets
    • Knowing the cost of capital can also help determine the required return for capital budgeting projects
    • Calculated when company is evaluating a project (not day-to-day)
    • Equivalent terms (all mean the same thing)
      • Required rate of return 
      • Cost of capital
      • Hurdle rate 
      • Discount rate 
      • Cost of equity
  • Cost of equity 
    • Return required by equity investors given the risk of the cash flows from the firm
    • Equity investors receive cashflow from the firm in two forms
      • Dividends (periodic)
      • Selling shares (terminal)
    • 2 major methods for determining the cost of equity 
      • Dividend growth model (DGM)
      • SML or CAPM

Dividend Growth Model 

  • Requirements
    • Dividend is expected to grow at a stable rate for the foreseeable future
    • Cost of capital > growth of dividend

D1 = next periods dividends, RE = cost of equity, g = growth, P0 = current priceXFeGVRTZTMQAAAABJRU5ErkJggg==

If D1 is not given: D1 = D0 x (1+g)

*calculating growth:

  • Using historical average (new – old)/old = percent change …. average these changes out
  • Accounting method:
    • 3 assumptions:
      • Stable ROE
      • Stable dividend policy 
      • Not planning on raising new external capital
    • Then: g = retention ratio x ROE
      • Retention ratio = (1-payout ratio)      
  • Advantages 
    • Easy to use and understand 
  • 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 – increasing g 1% increases cost of equity by 1%
    • Does not explicitly consider risk 

SML Approach

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  • Market risk premium = market rate – risk free rate
  • All equity company**
  • Advantages 
    • Explicitly adjusts for systematic risk 
    • Applicable to all companies as long as we can compute beta
  • Disadvantages 
    • Must estimate the expected market risk premium, which varies over time 
    • Must estimate beta, which also varies over time 
    • We are relying on the past to predict the future, not always reliable

Note: If 2 models diverge a lot: either average both rates or use SML

  • Cost of debt
  • Cost of debt is the required return on our company’s debt (Rd)
  • Usually focus on the cost of long-term debt or bonds 
  • Debt investors receive cashflow from the firm in two forms 
    • Coupon (periodic)
    • Selling bond or face/par value (terminal)
  • Required return is best estimated by computing the yield-to maturity on the existing bond
  • We may also use estimates of current rates based on the bond rating we expect when we issue new debt
  • Cost of debt is not the coupon rate (irrelevant)
  • ** excel
  • Cost of Preferred Stock
  • Preferred stocks generally pay a constant dividend every period 
  • Dividends are expected to be paid every period forever 
  • Preferred stock is a perpetuity and can be values by: Po = D/Rp
    • Rp = D / P0
      • D = dividend
      • P0 = current price
      • Rp = required return – growth

______________________________________________________________________________Weighted Average Cost of Capital 

  • average” is the required return on assets, based on the market’s perception of the risk of those assets 
  • The weights are determined by how much of each type of financing is being used – 2 methods:
    • Target D/E ratio
      • wE = 1 / 1+target D/E
      • WD = 1 – wE
        • 0r: WD= (target D/E) / (1 + target D/E)
    • Market value of debt and equity (weights)
      • Add up to 100%
      • wD + wE = 1
  • Capital structure weights 
  • Notation 
    • E = market value of equity = # outstanding shares * price per share 
    • D = market value of debt = # outstanding bonds * bond price 
    • V = market value of the firm = D + E
    • Target capital structure = D/E
  • Weights 
    • wE = E/V (% financed with equity)
    • wD = D/V (%financed with debt)
  • Impact of taxes 
    • We are concerned with after-tax cash flows, so we need to consider the effect of taxes on the various costs of capital 
    • Interest expense reduced tax liability 
      • This reduction in taxes reduces cost of debt 
      • After-tax cost of debt = Rd (1-Tc)
        • = Pretax rate*(1-tax rate)
      • Tax shield amount = (debt)*(coupon/Rd)*(tax%)
    • Dividends are not tax deductible, so there is no tax impact on the cost of equity



Divisional and Project Costs of Capital 

  • Using WACC to evaluate projects only appropriate for projects that have the same risk as the firm’s current operations
  • If a project under evaluation does NOT have the same risk as the firm, a different discount rate (not WACC) to be used
  • Divisions where the company is involved in different lines of business also require separate discount rates because they have different levels of risk
  • Using one WACC to evaluate all projects irrespective of their riskiness will lead the firm to accept more risky projects and reject less risky ones

Solution 1 – Pure Play Approach 

  • Use of a WACC that is unique to a particular project 
    • Use WACC of a “peer” group of companies 
      • Companies that specialize in the project that is being considered 
  • Compute the beta for each company in peer group, take an average, find the appropriate return for a project of that risk using CAPM
  • Often difficult to find pure play companies

Solution 2 – Subjective Approach 

  • Consider the project’s risk relative to the firm overall 
  • If the project is riskier than the firm, use a discount rate greater than the firm-wide WACC 
  • If the project is less risky than the firm, use a discount rate less than the firm-wide WACC
  • May result in incorrect acceptance and rejection, but the error rate should be lower than not considering differential risk at all


Company Valuation Using WACC

  • Companies are valued using the capital budgeting approach – discounting all cash flows of the firms to find the NPV
  • Process: future adjusted cash flows from assets (CFA) are discounting at WACC