Ch 9: Cost of Capital

Question 1

What is the WACC? What precautions must we take when measuring the WACC to use for capital budgeting decisions (future investment)?

Answer 1

• represents a firm’s avg cost of capital from all sources like common & preferred stock, bonds and other forms of debt.

Question 2

capital components

Answer 2

companies are financed by several sources of investor-supplied capital: long term debt and common stock

investors providing these require rates of return to make them wanna invest.

Question 3

What do we mean by “target capital structure”?

Answer 3

• the avg capital structure weights that a company will have during the future which should be the weights that minimize the company’s WACC

Question 4

What is the “marginal cost of capital”?

Question 5

after tax cost of debt

Answer 5

investor’s required rate of return on debt - issuer’s tax savings due to interest expense deductions

Question 6

short term debt

Answer 6

should be included in capital structure only if its a permanent source of financing
ex: notes payable

Question 7

marginal rate

historical rate/ embedded rate

Answer 7

1. required rate of return on new debt
2. average rate on previously issued debt for the company. determines the actual coupon payments a company must make to its debtholders to determine the rate of return a public utility should be allowed to earn.

company should use marginal rate

Question 8

alternatives to estimate cost of debt

Answer 8

1. use coupon rate on recently issued debt that’s trading at par
2. calculate the yield to maturity on previously issued debt even if it’s not trading at par
3. if no previously issued debt, estimate the yield using the avg yield other comparable companies have on their debt.

Question 9

YTM vs expected rate of return

Answer 9

• coupon and principal cash flows the bond promises to pay are the max cash flows the investors will receive.
• expected must be less than promised. so expected must be < YTM.

use YTM for WACC because it is the rate of return a company requires to meet it’s debt obligations

Question 10

flotation costs

net issue price

Answer 10

• commisions, legal expenses, fees and any other costs a company incurs when it issues new securities.
• amount per bond the issuing company actually receives after it pays flotation costs

Question 11

constant yield method

de minimis

Answer 11

finding the after tax cost of debt but replacing the bond’s actual issue price with the net issue price.

the minimum amount of discount on a bond’s issue price that qualifies for the bond discount. if flotation cost > or = de minimis, use constant yield method

Question 12

if flotation costs < de minimis

Answer 12

use allocation method (allocate flotation costs in equal portions to each payment period, determine issuer’s after-tax payments and then find YTM using after tax payments)

1. calculate after tax coupon payment
2. allocate flotation costs equally and determine impact on taxes
3. total after tax cost of = step 1 - step 2

Question 13

total net discount

total net premium

Answer 13

1. bond is issued at a discount (issue price < par value). equal to price - flotation costs. use constant yield method if total net discount is > de minimis
2. issue price > par value. if price - flotation costs = less than pay, the bond has total net discount. if its more, it’s this. use constant yield.

Question 14

cost of preferred stock

Answer 14

not tax deductible so no tax adjustment. preferred dividends are paid because 1) they can’t pay dividends on common stock 2) they’ll find it difficult to raise more funds in the capital market 3) preferred stockholders can take control of the firm

• cost used in WACC
• riskier than debt, return is higher.

Question 15

required rate of return on stock (Rs)

cost of common stock

Answer 15

• rate shareholders require.

- cost company’s inccur

Question 16

forward looking risk premiums

Answer 16

assumes: all distributions are dividends, and dividends will grow at a constant rate

Question 17

2 ways companies can raise common equity

Answer 17

1. sell newly issued shares to the public

2. reinvest (retain) earnings by not paying out all net income as dividends

Question 18

Common stock

Answer 18

-required rate of return on common stock is the cost of common equity raised internally via reinvested earnings.

if a company can’t earn at least Rs, on reinvested earnings, they should pass those earnings on to its stockholders as dividends.

Question 19

Using CAPM to estimate cost of common stock

Answer 19

1. estimating Rrf - normally use rate on 10 year bonds
2. estimating RPm - usually between 3-7%
3. Estimating Beta -

required return for investor is a cost of equity for company

Question 20

Using Dividend Growth to estimate cost of common stock

Answer 20

• based on constant growth dividends. if the company makes all payouts in the form of dividends (does not repurchase)
• aka div capitalization method bc it determines a stock’s price by capitalizing its dividends
• Need: current stock price, current dividend and marginal investor’s expected dividend growth rate
• expected growth rate: companies grow more by reinvesting or earning higher rate of return on equity so use these facts to estimate growth rate.

Question 21

payout ratio
retention ratio
retention growth equation

Answer 21

1. % of net income the firm pays out in dividends
2. % of net income that’s reinvested and added to retained earnings
3. shows how growth is related to reinvestment

Question 21

payout ratio
retention ratio
retention growth equation

Answer 21

1. % of net income the firm pays out in dividends
2. % of net income that’s reinvested and added to retained earnings
3. shows how growth is related to reinvestment

Question 22

WACC weights

Answer 22

should use market value weights expected on average in the future

Question 23

adjusting the cost of equity for flotation costs

Answer 23

-a reason for higher equity flotation costs is that corporate debt is sold mainly in large blocks wheras common stock is sold in smaller amounts to more investors.

Question 24

cost of new external common equity (Re)

Answer 24

• a project financed with external equity must earn a higher rate of return because it has to cover the flotation costs. So, the new common equity is higher than the common equity raised internally by reinvesting earnings.

Question 25

Privately owned firms

Answer 25

• to estimate beta: most analysts use the beta of publicly traded companies of the same size.
• if they’re wondering what their current actual capital structure is: everything is estimated.

Question 26

own bond yield plus judgemental risk premium approach

Answer 26

cost of stock could be > than cost of debt because equity is riskier than debt so some analysts add a risk premium of 3-5% to the cost of debt.

Question 27

Using CAPM to estimate the divisional cost of capital

Answer 27

divisional- several business lines.

find the required return and then new beta and put in required return formula again

Question 28

estimating divisional betas

Answer 28

1. pure play method- find beta of several publicly held companies in the same line of business and average those betas to determine the cost of capital.
2. accounting beta method- run a regression of the division’s accounting return on assets against the average return on assets for a large sample of companies

Question 29

estimating the cost of capital for individual companies

Answer 29

3 ways to view a project’s risk:

1. stand alone risk- risk a company has if it only had this one project.
2. corporate/within-firm risk- the project represents only one asset of the firm’s portfolio so some of its risk will be diversified away by other projects.
3. market/beta risk- risk of a project seen by a diversified stockholder that owns many different stocks.

-market risk has most effect on stocks.
Step 1: determine cost of capital
Step 2: establish risk categories for projects
Step 3. use step 1 and 2 to determine risk-adjusted cost of capital, r, (hurdle rate). project’s expected must get over this rate to be accepted.

Question 30

managerial issues and cost of capital

Answer 30

factors a firm can’t control: interest rates, credit crises, market risk premium, tax rates.

factors the firm can control: capital structure policy, dividend policy, investment (capital budgeting) policy

mistakes to avoid: don’t base the cost of debt on the coupon rate on a firm’s existing debt, when estimating the market risk premium for CAPM, don’t use the historical avg return on stock with current return on T bonds, don’t use the current book value to get WACC weights, capital components are funds that come from investors.