TiEYouth
TiEYouth
• Largest Entrepreneurship Conference in the world • Interact with real entrepreneurs and receive valuable advice • Learn tricks of the trade in starting your own business
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• Details • Saturday, May 18 from 2:30-‐4:45pm • Santa Clara Conven&on Center • 20 &ckets available for $20 each (usually $35) • Interested? • Register at h"p://bit.ly/WNTCbp • Ques&ons? • Contact Terry Koh 3
h"p://&econ.org/entrepreneurship/youth
Bloomberg Aptitude Test
Bloomberg Aptitude Test
Free 2-‐h exam to assess an individual's aptitude relevant to opportunities in business and =inance
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h"p://&econ.org/entrepreneurship/youth
• Details • Sunday May 19th 3-‐5pm or Saturday May 25th 3-‐5pm • Social Sciences 1 PC (Room 135) • Interested? • Register at www.takethebat.com (space is limited) • Ques&ons? • Contact Jennifer Pak 5
h"p://about.bloombergins&tute.com/students/
Midterm 1
Midterm 1 (42 points max)
6
Points
Grade
41 -‐ 42
A+
38.5 – 40.5
A
36 – 38
A-‐
33.5 – 35.5
B+
31 – 33
B
28.5 – 30.5
B-‐
26 – 28
C+
Marriott Corporation
23.5 – 25.5
C
Case study
21 – 23
D
0 – 20.5
F
7
1-1
Marrio" Corpora&on case
Marriott hurdle rate
Cost of Capital Week 6
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9
• Cost of capital • Minimum expected return an investment must offer to be a"rac&ve • Opportunity cost of using capital for real assets rather than financial assets of the same systema&c risk • Required return • Hurdle rate • Discount rate for capital budge&ng projects
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Uses of the cost of capital • Capital budge&ng and valua&on • Discount rate for discoun&ng free cash flows (NPV calcula&on)
• Capital structure
Cost of capital
Cost of capital
De=inition and synonyms
• Pay bonus if return exceeds cost of capital
Finding the cost of capital
• Cost of capital associated with an investment depends on its risk • Cost of capital indicates how the market views the risk of our assets
• Cost of capital depends on the use of capital, not its source
Cost of capital
• Return earned on assets depends on the risk of those assets
Cost of capital
• Incen&ve compensa&on
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Cost of capital and risk
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• Op&mal/target capital structure minimizes the cost of capital
• Calcula&on (in theory) Real rate of interest + Expected infla&on premium = Nominal rate of interest + Risk premium = Cost of capital • Appropriate risk premium is hard to determine • Use company’s or compe&tors’ WACC instead
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1-2
Weighted Average Cost of Capital (WACC)
Cost of equity (RE)
• Overall return the firm must earn on its assets to maintain the value of the stock • Required return on the firm’s assets based on the market’s percep&on of their risk
• = wERE + wDRD(1-‐TC)
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• Required return on equity
Cost of capital
Cost of capital
• Cost of capital for the firm as a whole
• Example • Your company is expected to pay a dividend of $1.50 per share next year and then to increase dividends by 5.1% per year • The current stock price is $25 • RE = 1.50/25 + 0.051 = 11.1%
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Cost of capital
D (1+ g) D RE = 0 +g= 1 +g P0 P0
Cost of capital
• Dividend growth model • SML or CAPM
Example: Estimating the dividend growth rate using historical average
• Rearrange the DGM to solve for R
• Year Dividend Percent Change 1995 1.23 (1.30–1.23)/ 1.23= 1996 1.30 (1.36–1.30)/ 1.30= 1997 1.36 (1.43–1.36)/ 1.36= 1998 1.43 (1.50–1.43)/ 1.43= 1999 1.50 • Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%
5.7% 4.6% 5.1% 4.9%
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• Advantage • Easy to understand and use • Disadvantages • Only applicable to companies currently paying dividends • Not applicable if dividends aren’t growing at a reasonably constant rate • Extremely sensi&ve to the es&mated growth rate – an increase in g of 1% point increases the cost of equity by ≥1% point • Does not explicitly consider risk
SML/CAPM approach
Cost of capital
Advantages and disadvantages of DGM
Cost of capital
• Two methods for determining RE
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The dividend growth model approach
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• Return required by equity investors given the risk of the cash flows from the firm
• Use CAPM to compute our cost of equity • Risk-‐free rate, Rf • Market risk premium, E(RM) – Rf • Systema&c risk of stock, βE • E(RE) = Rf + βE(E(RM) – Rf) • Example • Your company has a β=0.58. Risk-‐free rate is 6.1%. Expected market risk premium is 8.6% • RE = 6.1 + .58(8.6) = 11.1%
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1-3
• Advantages • Explicitly adjusts for systema&c risk • Applicable to all companies, as long as we can compute beta • Disadvantages • Have to es&mate the expected market risk premium, which varies over &me • Have to es&mate beta, which varies over &me • Relying on the past to predict future
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Example: Cost of equity
Cost of capital
Cost of capital
Advantages and disadvantages of SML
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Cost of debt (RD)
Example: Cost of debt
• Focus on cost of long-‐ term debt or bonds • Best es&mated by the YTM on the exis&ng debt • May also use es&mates of current rates based on the bond ra&ng we expect when we issue new debt
• The cost of debt is not the coupon rate
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Cost of capital
Cost of capital
• Required return on the company’s debt
Example: Cost of debt with multiple bonds
• Take weighted average of YTMs
• Bond 1 • BV = 100 • P = 95 • YTM = 5%
• Weights equal to market value of each issue
• Market value = price in $ * # of bonds outstanding = price as % of par value * current BV of issue
• Bond 2 Cost of capital
Cost of capital
• Our currently outstanding bond issue has 25 years lew to maturity • Coupon rate is 9%, paid semiannually • Bond is currently selling for $908.72 • Solu&on • 908.75=(45/R)(1-‐1/(1+R)50)+1000/(1+R)50 • R = 5% • RD = YTM = 2*R = 10%
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Cost of debt with multiple bonds outstanding
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• Suppose our company has a beta of 1.5. The market risk premium is 9% and the current risk-‐ free rate is 6% • The market believes our dividends will grow at 6% p.a. and our last dividend was $2. Our stock is currently selling for $15.65. What is our cost of equity? • SML: RE = 6% + 1.5(9%) = 19.5% • DGM: RE = [2(1.06) / 15.65] + .06 = 19.55%
• BV = 20 • P = 90 • YTM=10%
• Market values • MV1 = 95% * 100 = 95 • MV2 = 90% * 20 = 18 • Total MV = 95 + 18 = 113
• Cost of debt RD = 95/113 * 5% + 18/113 * 10% = 5.8%
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1-4
Cost of preferred stock
Capital structure weights
• Preferred stock is a perpetuity
• Example
Cost of capital
Cost of capital
• Preferred stock generally pays a constant dividend every period forever • RP = D / P0 • Your company has preferred stock that has an annual dividend of $3. Current price is $25 • RP = 3 / 25 = 12%
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Debt and taxes • We are concerned with awer-‐tax cash flows • Interest expense reduces our tax liability
• Your MV of equity is $500 million and the MV of debt is $475 million • V = 500 million + 475 million = 975 million • Weights are determined by how much of each type of financing we use • wE = E/V = 500 / 975 = .5128 = 51.28% • wD = D/V = 475 / 975 = .4872 = 48.72% • wP = P/V = 0 / 975 = 0%
Cost of capital
Cost of capital
Example: Capital structure weights
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• Dividends are not tax deduc&ble, so the cost of equity is unaffected by tax
-‐ Interest = Taxable income
Weighted Average Cost of Capital: WACC = wERE + wPRP + wDRD(1-‐TC)
$400m of bonds $100 -‐ $100
EBIT
$100
-‐ Interest (5%)
$20
= Taxable income
$80
-‐ Taxes (25%)
$25
-‐ Taxes (25%)
$20
= Net income
$75
= Net income
$60
• Before-‐tax cost of debt is $20 (= 5% * 400) • Awer-‐tax cost of debt is $20 -‐ 5 = $15 • $15/$400 = 3.75% • 3.75% = 5% (1 -‐ 25%)
Cost of capital
No debt EBIT
Cost of capital
• Reduced taxes reduce our cost of debt • Awer-‐tax cost of debt = RD(1-‐TC)
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Example: after-‐tax cost of debt
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• Nota&on • E = MV of equity = # outstanding shares * price per share • D = MV of debt = # outstanding bonds * bond price • V = MV of the firm = D + E • Capital structure weights • wE = E/V = percent financed with equity • wD = D/V = percent financed with debt
• Weights are determined by how much of each type of financing we want to use • Weights should reflect target ra&os, not current ones
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1-5
Example: WACC
• 50 million shares • $80 per share • Beta = 1.15 • Market risk premium = 9% • Risk-‐free rate = 5%
• Debt Informa&on • 1 million bonds outstanding • $1,000 face value • Current quote = 110 • Coupon rate = 9%, semiannual coupons • 15 years to maturity
• Tax rate = 40%
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Cost of capital
Cost of capital
• Equity Informa&on
Example: WACC
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• Capital structure weights • E = 50 million (80) = 4 billion • D = 1 million * 1,000 * 1.10 = 1.1 billion • V = 4 + 1.1 = 5.1 billion • wE = E/V = 4 / 5.1 = .7843 • wD = D/V = 1.1 / 5.1 = .2157 • WACC = .7843 (15.35%) + .2157 (4.712%) = 13.06%
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Divisional and project costs of capital
Cost of capital
Cost of capital
Example: WACC
• WACC is only appropriate as our discount rate for projects that are the same risk as the firm’s current opera&ons • If the project is more or less risky than the firm as a whole, we need to determine the appropriate discount rate for that project • Divisions also owen require separate discount rates (e.g., GE)
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• What would happen if we use the WACC for all projects regardless of risk? • WACC = 15% • Project Required Return IRR • A 20% 17% • B 15% 18% • C 10% 12%
Choosing the right discount rate
Cost of capital
Example: Using WACC for all projects
Cost of capital
• Cost of equity • RE = 5 + 1.15(9) = 15.35% • Cost of debt • 1100=(45/R)(1-‐1/(1+R)30)+1000/(1+R)30 • R = 3.9268 • RD = 3.927(2) = 7.854% • Awer-‐tax cost of debt • RD(1-‐TC) = 7.854(1-‐.4) = 4.712%
• If project has the same riskiness as the firm overall and the firm has traded stock, use the firm’s own WACC • Applies to any scale-‐extending project • Does not apply to scope-‐extending projects • Otherwise, use (in descending order of preference) • Pure play approach • Find relevant, specialized compe&tors • Use the average of their costs of debt and equity
• Subjec&ve approach • Use your own WACC and adjust it subjec&vely
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38
1-6
Pure play approach
Beta and leverage
• Find the equity beta for each company • Unlever each beta to get the asset beta • Take an average of asset betas • Relever the average asset beta
• Use that beta with the CAPM to find the appropriate cost of equity for the product • Difficult to find pure play firms
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Cost of capital
Cost of capital
• Find companies that specialize in the product we are considering (pure plays)
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• Unlever beta for each pure play compe&tor • Observe βE for each compe&tor • Calculate βA= E/V βE • Use compe&tors‘ actual capital structures • Take average of asset betas • Relever average asset beta (calculate βE) for firm’s or project’s financial risk (leverage) • βE = βA V/E • Use firm’s (or division’s) target capital structure • Use βE in CAPM to get cost of equity
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Cost of capital
Cost of capital
• Pure play 2
• Take average of asset betas
• Our firm
• Relever average asset beta
• E/Vactual = 55% • E/Vtarget = 50%
• Market
• RF = 2% • MRP = 8%
• βA,1= 60% * 1.2 = 0.72 • βA,2= 80% * 1.5 = 1.2
• βA = (0.72 +1.2)/2 = 0.96 • βE = βA V/E • = 0.96 * 1/50% = 1.92
• Use βE in CAPM
• RE = 2% + 1.92 * 8% • = 17.4%
V = E+D
Example: Subjective approach
• Consider the project’s risk rela&ve to the firm overall
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• Unlever betas
• E/V = 80% • βE = 1.5
Subjective approach
• You may s&ll make wrong decisions, but your error rate should be lower
• Pure play 1 • E/V = 60% • βE = 1.2
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• If the project is more risky than the firm, use a discount rate greater than the WACC • If the project is less risky than the firm, use a discount rate less than the WACC
V = D + E
Example: Unlevering and relevering beta
Cost of capital
Cost of capital
Unlevering and relevering beta
• β increases in the systema&c components of business risk and financial risk • Relevant pure plays have the same business risk, but different levels of financial risk • Need to adjust for different financial leverage • Asset (or firm) beta = βA = βunlevered • Reflects business risk of asset • Unaffected by capital structure • Beta of por{olio of debt and equity = weighted avg. of betas • βA= E/V βE + D/V βD • Assuming the debt is riskless (βD=0): βA= E/V βE
Risk Level
Discount Rate
Very Low Risk
WACC – 8%
Low Risk
WACC – 3%
Same Risk as Firm
WACC
High Risk
WACC + 5%
Very High Risk
WACC + 10%
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1-7
