Cost of Capital Basics

Transcription

1 Cost of Capital Basics The corporate cost of capital is a blend (weighted average) of the costs of the financing components. It is used as a benchmark rate of return in new new project evaluations. Key considerations: Capital components to include Handling of tax benefits Historical versus marginal costs Estimating the Component Cost of Debt Discuss debt costs with banker: Investment banker if bonds are used. Commercial banker if loan is used. Look at YTM on outstanding issues if they are actively traded. Look to the debt markets for guidance. Find the interest rate on recent issues: By companies with same debt rating. By companies that are similar. Component Cost of Debt (Cont.) For a not-for-profit organization, the component cost of debt is the interest rate on a new issue. An investor-owned organization must consider the tax benefits of debt: Assume that Valley Clinic (VC) has a 40% tax rate. According to its bankers, a new bank loan would have an interest rate of 10%. Its component (effective) cost of debt would be 10% x (1 - T) = 10% x 0.6 = 6.0%.

2 Component Cost of Debt (Cont.) Issuance costs are typically small and hence can be ignored in the debt cost estimate. Also, the difference between the stated rate and EAR is typically small, so the stated rate generally is used.? Does ownership (FP versus NFP) have a significant effect on the component cost of debt? Component Cost of Equity The component cost of debt is the return required by debt suppliers, and the component cost of equity is defined similarly. For now, we will consider investorowned businesses. The primary sources of equity are: Retained earnings. New common stock sales. Component Cost of Equity (Cont.) The cost of new common stock is the return that investors require on that stock. There is an opportunity cost associated with retained earnings: If earnings are retained rather than paid out as dividends, the stockholders bear an opportunity loss. These funds could be reinvested in alternative investments of similar risk.

3 Component Cost of Equity (Cont.) Thus, retained earnings have roughly the same component cost as does new common stock. There are two primary methods used to estimate the component cost of equity in for-profit businesses: Capital Asset Pricing Model (CAPM) Discounted cash flow (DCF) model CAPM Method The Capital Asset Pricing Model (CAPM) is a equilibrium model that relates market risk to required rate of return. The equation used is the Security Market Line (SML): R(R s ) = RF + [R(R M ) - RF] x b i. CAPM Method (Cont.) Where do we get the input values? RF is the rate on T-bonds. R(R M ) can come from: Brokerage house estimates Historical data Betas come from investment analysts.? Which input is the weak link in the DCF method?

4 Some Recent (1998) Beta Estimates Alza Drug delivery systems 1.40 Baxter Medical Supplies 1.10 Beverly Enterprises Nursing homes 1.20 Glaxo Wellcome Diversified drugs 1.00 HEALTHSOUTH Rehabilitative care 1.35 Humana Managed care 1.55 Phycor Practice management 1.35 Tenet Healthcare Acute care hospitals 1.00 U.S. Surgical Medical Equipment 1.30 Valley Clinic (VC) Outpatient care 1.10 Source: Value Line? What do these values tell us? CAPM Method (Cont.) What is Valley Clinic s component cost of equity if RF = 8.5%, RP M = 5%, and, according to slide 13-4, b VC = 1.1? R(R VC ) = RF + [R(R M ) - RF] x b VC = 8.5% + (5.0% x 1.1) = 14.0%.?What does RP M stand for? DCF Method The discounted cash flow (DCF) approach assumes that stock price is the present value of the expected dividend stream. The DCF method can be used both with constant and nonconstant growth, but the calculations are more complicated when growth is nonconstant.

5 DCF Method (Cont.) Under constant growth assumptions, the DCF model is as follows: E(R s ) = R(R s ) = E(D 1 ) P 0 + E(g). DCF Method (Cont.) Where do we get the input values? P 0 comes from the Wall Street Journal (or many other sources). E(D 1 ) can come from: Analyst s estimates Historical D 0 multiplied by E(g) E(g) from stock analyst s forecasts.? Which input is the weak link in the DCF method? DCF Method (Cont.) Assume that P 0 = $40, E(D 1 ) = $2.72, and E(g) = a constant 7.0% for Valley Clinic. Then, E(D R(R VC ) = 1 ) $ E(g) = + 7.0% P 0 $40 = 6.8% + 7.0% = 13.8%.

6 Equity Issuance Costs Issuance costs on equity sales are larger than on debt sales. Two methods are used to adjust the cost of equity for issuance costs: Adjust project cost. Adjust cost of equity, which produces two costs: one for retained earnings and one for new stock sales. We will ignore issuance costs. DCF Method (Cont.) When CAPM and DCF estimates for the component cost of equity differ, judgment must be applied. For our provider, the CAPM estimate is 14.0% and the DCF estimate is 13.8%. A reasonable final estimate is 13.9%.? What happens when the two estimates differ by a wide margin? Assume target weights of 35% debt and 65% equity. What is Valley Clinic s corporate cost of capital (CCC)? CCC = w d x R(R d ) x (1 - T) + w s x R(R s ) = (0.35 x 10% x 0.6) + (0.65 x 13.9%) = (0.35 x 6.0%) + (0.65 x 13.9%) = 2.1% + 9.0% = 11.1%.

7 What factors influence a company s corporate cost of capital? Market conditions. The firm s risk: Business risk, as reflected by the inherent risk in the business line and the firm s use of operating leverage. Financial risk, as reflected by the amount of financial leverage (debt financing) used. The corporate cost of capital will be used as the hurdle rate for evaluating capital projects. Would the same rate be applied to all projects? No. The corporate cost of capital reflects the risk of the firm s average project. It can be used only for projects with average risk. The corporate cost of capital must be adjusted when the project has nonaverage risk. Risk and the Cost of Capital Cost of Capital (%) Corporate Low Average High Risk