CORPORATE FINANCE COST OF CAPITAL. Reading

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1 CORPORATE FINANCE COST OF CAPITAL Reading

2 Popularity of Capital Budgeting Methods Location European companies follow payback period as decision making criteria. Size Bigger companies more likely to use NPV as selection criteria. Public v/s Private Companies Private companies more likely to use payback period. Management Educated managers more likely to use NPV 2

3 Cost of Capital It is the rate that suppliers of capital bondholders and owners require as compensation for their contribution of capital. It is the minimum rate of return that a company must earn on its investment, returns are required to satisfy various stakeholders. Failing on returns generation will result in the loss of the investors faith on the company and he may be compelled to pull his money out. As we use cost of capital in evaluation of investment opportunities we are dealing with a marginal cost what it would cost to raise additional funds for potential investment projects. 3

4 Components of Cost of Capital All the costs put together help us compute the Weighted Average Cost of Capital (WACC) Cost of Term Loan Cost of Debt Cost of Preference Share Cost of Equity WACC Cost of Term Loan Cost of Debenture Cost of Preference Share Cost of Equity 4

5 WACC Calculation WACC = w d r d (1 t) + w p r p + w e r e Where, w d weightage of debt in overall capital r d cost of debt t Company s tax rate w p weightage of preference shares r p cost of preference shares w e weightage of equity r e cost off equity 5

6 Taxes and Cost of Capital Company I Company II Remarks Method I Equity (10% dividend) Capital raised in form of equity Debt (10% Interest Rate) Capital raised in form of debt Total Capital Total Capital raised Operating Profit (EBIT) Interest PBT % PAT Dividend Retained Earnings Method II EBIT T NOPAT After Tax cost of debt 0 70 After tax cost of equity Cash Flow Interest 10% on the debt by Company II Savings of 30 in Tax due to Debt funding. Hence benefits wil be available only if debt is a part of the capital. Thus it reduces the cost of debt funding Net difference of 30 as interest on debt is tax deductible k d = I * (1-T) 6

7 Weights of WACC Target capital structure is the capital structure a company is striving to achieve Arrive at target capital structure Take it as current capital structure Examine trends in capital structure and look at management guidance Use averages of comparable companies target capital structure 7

8 WACC Example An analyst is estimating the cost of company Duke Ltd. The following information is provided Duke Ltd Market Value of debt = $ 30 million Market Value of equity = $ 40 million Competitor data: Competitor MV of Debt MV of equity A $ 34 $ 56 B $ 123 $ 170 C $ 50 $ Current Capital Structure? 2. Competitor Capital Structure? 3. Calculate the weights if Duke Ltd. Announces their target D/E ratio of 0.6? 8

9 WACC Solution: 1.) Current Capital Sturcture w d = 30 = ( ) w e = 40 ( ) = ) Competitor Capital Structure w d w e = = [34/(34+56)] + [123/( )] + [50/(50+70)] 3 [56/(34+56)] + [170/( )] + [70/(50+70)] 3 = = ) D/E = 0.6 w d = 0.6 ( ) = w e = 1 - w d = These would have been the preffered weights for the target D/E ratio. 9

10 Optimal Capital Budget MCC (Marginal Cost of Capital) A firm s MCC is the cost of an additional dollar of capital raised A firm s MCC increases as the firm increases the amount of capital it raises during a given period MCC curve slopes upward IOS (Investment opportunity schedule) We can order the opportunities for investment from highest to lowest IRR When we plot them we obtain the IOS Intersection of IOS and MCC identifies the optimal capital budget 10

11 Optimal Capital Budget 80 Project IRR 70 Cost of 60 Capital (%) Investment Opportunity Schedule Marginal Cost Of Capital 10 0 Optimal Capital Budget New Capital Raised (%) The WACC is the appropriate discount rate for projects that have same level of risk as that of the firm s existing projects. For projects with greater (lesser) risk use a discount rate greater (lesser) than the firm s existing WACC. 11

12 Cost of Debt Method I : Yield to Maturity Approach YTM is the annual return that an investor earns on a bond if the investor purchases the bond today and holds it until maturity. PMT 1 PMT 2 PMT 3 PMT n FV P 0 = (1 + kd) 1 (1 + kd) 2 (1 + kd) 3 (1 + kd) n (1 + kd) n Where, t = n PMT t FV = + t = 1 (1 + kd) t (1 + kd) n P 0 = Current value of Bond PMT = Interest Payment for a given period kd = Cost of debt FV = Future value of the bond 12

13 Cost of Debt Method II : Debt-Rating Approach When market price of debt is not available, debt rating approach is used. Based on company s debt rating estimate the before tax cost of debt by using the yield on a similarly rated bond for maturities that closely match with that of the company After Tax Cost of Debt = kd * ( 1 Tax Rate) Example Market price of debentures of company ABC is Rs.70. Debentures pay an interest rate of 7% and have a maturity of 5 years. Face value of the debentures is Rs.100 and the applicable tax rate for the company is 30% Solution PV = -70, FV = 100, N = 5, PMT = 7% * 100 * (1-30%) CPT I/Y = 13.54% 13

14 Cost of Preferred Stock Cost committed to the preferred stock holders while issuing preferred stock For nonconvertible, noncallable preferred stock that has a fixed dividend rate P p = D p / r p P p = Price of preferred stock D p = Dividend to preferred stock holder r p = cost of preferred stock r p = D p / P p Example ABC Corp has preferred stock outstanding, $5 cumulative preferred stock. The current price of this stock is $87. What is the cost of preferred equity? Solution: Cost of Preferred Equity = $5 / $ 87 = 5.75% 14

15 Cost of equity There are various measures by which cost of equity can be calculated. They are: Capital Asset Pricing Model (CAPM) Dividend forecast approach Bond yield plus risk premium 15

16 CAPM K e = R f + β (R m R f ) Where, Ke = Cost of Equity Rf = risk free rate of return Rm = market return β = beta of the stock (R m R f ) = Also called as Risk Premium To Remember Cost of equity as per the CAPM model is given as Ke = Rf + β (Rm Rf) Example ABC Corp wants to know the cost of equity? Its finance department believes the risk free rate is 5%, equity risk premium is 8% and beta is 2. Find the cost of equity? Solution: Cost of Equity = Rf + β (Rm Rf) = 5% + 2*(8%) = 21%. 16

17 Dividend forecast approach Where, K e = D 1 + g P 0 Ke = cost of equity D 1 = expected dividend at the end of year 1 P 0 = price per equity share g = growth rate g = Retention Ratio * Return on Equity g = b * ROE 17

18 Bond Yield plus risk premium Assumes Ke = bond market yield + risk premium Investors require higher return on a firm s equity than on its debt Risk premium normally ranges from 3% to 5% It is judgment based and hence imprecise 18

19 Estimating Beta and Project Beta Pure-Play Method (4 Steps) 1. Select a comparable company 2. Estimate the beta of the comparable company 3. Unlever the comparable s beta 4. Lever the beta for the project s financial risk Asset (Project) Unlevered Beta β Levered = β Unlevered * [ 1 + ( 1 - T ) D / E] β Unlevered = β Levered [ 1 + ( 1 - T ) D ] 19 E

20 Estimating Beta and Project Beta Example Estimate the WACC for the following details of XYZ Corp Nominal Risk Free Rate for 10-year government bond is 4% Average risk premium is 6% Corporate tax rate is 35% Target D/E = 0.6 Cost of Debt for XYZ Corp is at 275 bps premium to the government bond Following are the details of a comparable company Comparable MV of Tax Rate Mcap Company Debt D/E Beta ABC 40% 5,600 3, PQR 33% 13,000 15, STU 38% 2,300 3,

21 Estimating Beta and Project Beta Solution: WACC = w d r d (1 t) + w e r e D/E 0.6 w d = = (D/E + 1) ( ) w e = 1 = 1 (D/E + 1) ( ) k d = I * (1 - t) = 4% % = 6.75% k e = R f + β (R m R f ) k e = R f + β (R m R f ) = 4% * 6% = 9.19% = = Following the 4 Steps of the Pure Play Method Unlever the beta of the given comparable companies Comparable β Unlevered = β Levered Company [ 1 + ( 1 - T ) D ] E β Unlevered = β Levered = β Unlevered * [ 1 + ( 1 - T ) D / E] β L = * [ 1 + (1-0.35) * 0.6)] β L = Unlevered Beta ABC PQR STU Average WACC = w d r d (1 t) + w e r e WACC = 8.28% 21

22 Country Risk Premium Use of CAPm becomes difficult for developing countries. Hence a country risk premium needs to be added while calculating Ke with this method The country spread is referred to as a country equity premium K e = R f + β *[ (R m R f ) + Country Risk Premium] Country Risk Premium Soverign yield = * spread Annualized Standard Deviation of equity Index Annualized Standard Deviation of the soverign bond market in terms of the developed market currency 22

23 Country Risk Premium Example Given the following details regarding a project: Indian 10-yr sovereign bond yield = 7.7% 10-yr US Treasury Bond yield = 3.2% Annualized std. dev. Of Sensex = 23% Annualized std. dev. Of 10-yr USD denominated Indian sovereign bond = 12% Beta of project = 1.5 Expected Market Return = 11% Risk Free Rate = 5% Compute Cost of Equity 23

24 Country Risk Premium Solution: Market Risk Premium = 11% - 5% = 6% Country Risk Premium Soverign yield = * spread Annualized Standard Deviation of equity Index Annualized Standard Deviation of the soverign bond market in terms of the developed market currency Country Risk Premium = (7.7% - 3.2%) * (23% / 12%) = 8.625% Cost of Equity K e = R f + β *[ (R m R f ) + Country Risk Premium] K e = 5% * [ 6% %] K e = % 24

25 Marginal Cost of Capital MCC (Marginal Cost of Capital) A firm s MCC is the cost of an additional dollar of capital raised A firm s MCC increases as the firm increases the amount of capital it raises during a given period MCC curve slopes upward Breakpoint: The amount of new capital investment for which WACC increases because the cost of one of the component costs of capital increases is termed as breakpoint. Break Point = Amount of capital at which the sourc's cost of capital changes Proportion of new capital raised from the source E.g. cost of debt increases past $2 million. Raised debt is 40% of the target capital structure, Breakpoint = 2 /.4 = $5 million 25

26 Floatation Costs Fees charged by the investment banker when a company raises external equity capital is called as Floatation Cost These fees range between 2% to 7% Incorrect Method: Adjust cost of equity Formula D 1 ke = + g P 0 * (1 - f) Where, f is the floatation cost as a percent of issue price However cost gets incorrectly carried through the life of the project in this method Preferred Method: Adjust the initial cash outflow while computing NPV Correctly shows floatation cost as a cash outflow at inception of project. 26

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