Financial Policy and Cost of Capital

Big picture

• A firm's cost of capital reflects the required return on the firm's assets as a whole
• A firm uses both debt and equity capital
• Cost of capital will be a mixture

Cost of Equity

• The cost of equity is the return required by equity investors given the risk of the cash flows from the firm
• Business risk
• Financial risk
• There are two major methods for determining the cost of equity
• Dividend Growth Model
• SML, or CAPM

DGM Approach: Reminder

DGM: Pros and Cons

• Advantages
• easy to understand and use
• Disadvantages
• Requires a dividend payment
• Requires growth rate to be constant
• Extremely sensitive to growth rate estimate
• Does not explicitly consider risk

SML Approach: Reminder

SML or CAPM: Pros and Cons

• Advantages
• Explicitly adjusts for systematic risk
• Applicable to all companies, as long as we can estimate beta
• Disadvantages
• Have to estimate the expected market risk premium, which does vary over time
• Have to estimate beta, which also varies over time
• We are using the past to predict the future, which is not always reliable

Cost of Debt

• The cost of debt is the required return on our company's debt
• We usually focus on the cost of long-term debt or bonds
• The required return is best estimated by computing the yield-to-maturity on the existing debt
• The cost of debt is NOT the coupon rate

Weighted Average Cost of Capital (WACC)

• We can use the individual costs of capital that we have computed to get our "average" cost of capital for the firm
• This "average" is the required return on the firm's 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 used

Capital Structure Weights

• Notation
• E = market value of equity = # of outstanding shares times price per share
• D = market value of debt = # of outstanding bonds times bond price
• V = market value of the firm = D + E
• Weights
• $w_E = \frac{E}{V} =$ percent financed with equity
• $w_D=\frac{D}{V}=$ percent financed with debt

Taxes

• We are concerned with after-tax cash flows, so we also need to consider the effect of taxes on the various costs of capital
• Interest expense reduces our tax liability
• This reduction in taxes reduces our cost of debt
• Dividends are not tax deductible, so there is no tax impact on the cost of equity

WACC

Large Example

Go Nuts for Donuts! Inc.

Solution: Cost of Equity

• Dividend Growth Model
$R_E=\frac{D_1}{P_0}+g=\frac{3.5(1.06)}{80}+.06=.106375=10.64%$


• CAPM
$R_E=R_f+\beta_E(E(R_M)-R_f)=5+1.15(9)=15.35%$

Solution: Cost of Debt

• N=15*2=30
• I%=3.927*2=$7.854=R_D$
• PV=-1100
• PMT=90/2=45
• FV=1000

Solution: Weights

• E=50,000,000*80= 4 billion
• D=1,000,000,000*1.1=1.1 billion
• V=4 + 1.1 = 5.1 billion
• $w_E=\frac{E}{V}=\frac{4}{5.1}=.7843$
• $w_D=\frac{D}{V}=\frac{1.1}{5.1}=.2157$

Solution

• Using DGM:
$WACC=w_ER_E+w_DR_D(1-T_C)$
$WACC=.7843(10.64)+.2157*(7.854(1-.4)=9.36$
• Using CAPM:
$WACC=w_ER_E+w_DR_D(1-T_C)$
$WACC=.7843(15.35)+.2157*(7.854(1-.4)=13.06$

Another Large Example

Nike (Using real data)

Issues with WACC

SML and WACC

Divisions and WACC

• Using firm-level WACC can lead to:
• Incorrectly accepting high risk projects if $\beta$ of project is higher
• Incorrectly rejecting low risk projects if $\beta$ of project is lower
• Solutions:
1. Pure Play: Use similar investment(company) in marketplace
2. Subjective: Make risk adjustments to WACC.

Extra Practice

Example 1

1. Suppose your company has an equity beta of .58, and the current risk-free rate is 6.1%. If the expected market risk premium is 8.6%, what is your cost of equity capital?
2. Suppose that your company is expected to pay a dividend of $\$$1.50 per share next year. There has been a steady growth in dividends of 5.1% per year and the market expects that to continue. The current price is $\$$25. What is the cost of equity?
3. Suppose we have a bond issue currently outstanding that has 25 years left to maturity. The coupon rate is 9%, and coupons are paid semiannually. The bond is currently selling for $\$$908.72 per $\$$1,000 bond. What is the cost of debt?

Example 2

Example 3