FINS1613 Lecture Notes - Lecture 7: Risk-Free Interest Rate, Risk Premium, Capital Asset Pricing Model

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Chapter 13 – Cost of Capital

- Capital structure: relative proportions of debt, equity and other securities the firm

has outstanding

- Market value of E + MV(D) = MV(A) (means D/E is derived from underlying assets)

- Cost of capital: required rate of return a co must offer investors for a project to

compensate them for risk- discount rate used when valuing projects

- Weighted average cost of capital (WACC)

o Weighted ag of a pojet’s osts of apital fo eah seuit used i

financing- weights are fractional aouts of eah seuit’s total pojet

market value

o Expected return premium on any asset is proportional to its systematic risk

▪ Offer investments that meet return expectations of markets- +ve NPV

when discounted at expected return- return necessary cost to co for

investor capital

= Asset cost of capital

r(WACC) = r(E)*E% + r(P)*P% + r(D)*(1-Tc)*D%

- Project as a portfolio: return of a portfolio = weighted avg return of the securities

w/in

o Offer a return = to weighted avg of expected returns → based on market

values

- Firm w/out debt- unlevered vs. debt outstanding = levered (WACC for unlevered =

r(E)

o Values assets by discounting CF at WACC – NPV + total aket alue of fi’s

securities when applied to total firm CF

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- Implicitly assumes relative aket alues of fi’s seuities do ot hage o/t

- CAPM limitations: used to find cost of capital for any asset/security- D/E

- Asset/security values must be current w reliable market values → debt

seuities/pef shaes do’t tade feuetl + listed P may be outdated- estimated

CAPM ß unreliable + ordinary shares generally valued using CAPM

- Cost of Debt: Debt paym tax deductible- fi do’t ea full ost of det → cost of

debt used in WACC reflect tax benefits of debt- YTM is expected return on debt

required by investors; r(D)= YTM, T(C)= firm tax rate

o Do’t use CPN ate histoial as det ost of apital- YTM of existing debt

- Unlevered: cost of capital for assets is same as r(E) for equity- FCF to equity holders =

FCF from assets

- Net debt= debt – cash and risk free securities (ie use market value of equity and net

det)

- Cost of Preference shares: Offer fixed dividend- reflect expected return demanded

by investor- constant growth dividend model

→ constant dividend growth model: r(P) = Div/P(0) + g

- Cost of Ordinary shares: Risk free rate (LT gov bonds), market risk premium

histoial ≈ 5.5-7%), appropriate ß reflect project systematic risk (industry avg)

- CAPM: obtain beta of equity or estimate

o Determine risk free rate (yield on treasury bonds)

o Estimate market risk premium (compare historical returns on market proxy

to historical risk free rate)

- Assuptios: average risk, costat D/E ratio (WACC does’t chage accordig to

leverage changes- assume maintain constant ratio), limited leverage effects (only

interest tax deduction- assue other fiacial stress factors are’t sigificat i level

of debt chosen) [also, issuance costs cash outflows

→

internal funds less costly than

external funding]

WACC: determine incremental FCF of investment → WACC → compute value of investment

incl tax benefit of leverage, by discounting incremental FCF of investment using WACC

- Cost of apital fo pojet’s CF he a pojet’s isk diffes fo the fi’s oeall isk

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Estimating the cost of equity

CAPM

CDGM

Inputs

- Equity beta

- Risk free rate

- Market risk premium

- Current share price

- Expected dividend next year

- Future dividend growth rate

Assumptions

- Estimated beta is correct

- MRP is accurate

- CAPM is correct model

- Dividend estimate is correct

- Growth rate matches market expectations

- Future dividend growth is constant

Flotation costs

- Cost incurred by co when issuing securities- underwriting, legal, rego

o Incl costs at t=0 expense OR adjust r(E) to account for flotation costs

(assumes issuance costs are recurrent/ongoing expenses

Cost of Capital Part 3

- Tradeoffs between debt and equity

- Debt-to-value ratio (D/D+E)

- Raising capital: selling equity to private investors (control risk of administration +

equity rights)

o VC

o Institutional investors (target high risk)

o Corporate investors (strategic- related industries)

- IPO: provides a way for a successful young firm to raise additional capital

o Seed investors realise profits, firm sell shares extract cash, Board (decrease

share control)

▪ Pricing: generally underpriced (volatility) + generally underperform

the market 3-5years from IPO

▪ Cyclicality: business cycle (IPO vs other source of capital)

o Seasoned equity offering (SEO) occurs when a publicly traded firm sells

additional shares

- Raising debt:

o Private debt- fiaig ot pulil taded aoid ego osts, iestos a’t

really sell the debt e.g bank loans) vs. public debt (publicly traded)

o Debt securities- seniority (during administration), collateral

(secured/unsecured debt- backed by assets), covenants (restrictions on firm

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Document Summary

Capital structure: relative proportions of debt, equity and other securities the firm has outstanding. Market value of e + mv(d) = mv(a) (means d/e is derived from underlying assets) Cost of capital: required rate of return a co must offer investors for a project to compensate them for risk- discount rate used when valuing projects. = asset cost of capital r(wacc) = r(e)*e% + r(p)*p% + r(d)*(1-tc)*d% Project as a portfolio: return of a portfolio = weighted avg return of the securities w/in: offer a return = to weighted avg of expected returns based on market values. Firm w/out debt- unlevered vs. debt outstanding = levered (wacc for unlevered = r(e: values assets by discounting cf at wacc npv + total (cid:373)a(cid:396)ket (cid:448)alue of fi(cid:396)(cid:373)"s securities when applied to total firm cf. Implicitly assumes relative (cid:373)a(cid:396)ket (cid:448)alues of fi(cid:396)(cid:373)"s se(cid:272)u(cid:396)ities do (cid:374)ot (cid:272)ha(cid:374)ge o/t. Capm limitations: used to find cost of capital for any asset/security- d/e.

Related Questions

1. Last year, Logistics paid an annual dividend of $2.20 and announced that all future dividends would be $2.25 a share indefinitely. What is your required rate of return if you are willing to pay $15.25 a share for this stock?

14.50%

14.75%

16.07%

13.67%

13.88%

2. Which one of these factors generally has the greatest impact on a firmâs PE ratio?

depreciation method used by the firm

required rate of return

current dividends

the overall risk level of the current firm

future opportunities

3. When calculating the weighted average flotation cost, the weights should be based on the:

average amounts of external capital raised during the past twelve months.

firmâs target capital structure.

percentages of internal and external financing that will be used for the project.

firmâs current mix of debt and equity.

mix of debt and equity that will be used to finance the specific project.

4. The beta of a security is calculated as: (_____ of a securityâs return with the return on the market portfolio / _______).

Variance; Covariance of the security return

Covariance; Standard deviation of the market return

Covariance; Variance of the security return

Variance; Covariance of the market return

Covariance; Variance of the market return

5. A bond with a coupon rate of 6 percent that pays interest semiannually and is priced at par will have a market price of _____ and interest payments in the amount of _____ each.

$1,060; $30

$1,000; $60

$1,060; $60

$1,000; $30

$1,006; $60

6. The weighted average cost of capital for a firm is the:

maximum rate which the firm should require on any projects it undertakes.

overall rate which the firm must earn on its existing assets to maintain its value.

rate of return that the firm's preferred stockholders should expect to earn over the long term.

discount rate which the firm should apply to all of the projects it undertakes.

rate the firm should expect to pay on its next bond issue.

7. Jack's Construction Co. has 80,000 bonds outstanding that are selling at par value. Bonds with similar characteristics are yielding 8.6 percent. The company also has 4 million shares of common stock outstanding. The stock has a beta of 1.1 and sells for $40 a share. The U.S. Treasury bill is yielding 4 percent and the market risk premium is 8 percent. Jack's tax rate is 34 percent. What is Jack's weighted average cost of capital?

11.39%

10.65%

11.47%

10.43%

10.10%

8. Martin's Yachts is expected to pay annual dividends of $1.40, $1.75, and $2.00 a share over the next three years, respectively. After that, the dividend is expected to remain constant. What is the current value per share at a discount rate of 14 percent?

$13.39

$12.82

$12.22

$13.08

$13.57

Finance Tutor Help ASAP. Please answer all questions from a through g

Consider the following claims. Answer them with âTrueâ or âFalseâ and your explanation. No credit will be given if no explanation is shown.

Please provide explanation

a) All firms can issue debts if their asset values are sufficient enough. In particular,

the values of the firms will always increase as they raise more debts since interests on corporate debts are tax-deductible.

b) If the capital market is so efficient that all essential information for the firmsâ values is disclosed in the public, then there is no chance for any investor to make a profit.

c) One of the drawback of Net Present Value principle is that one will easily tend to accept the project(s) that have less years of cash flows - if other things being equal.

d) The expected rate of return for a stock when determined by the Capital Asset Pricing Model (CAPM) is the âgoal (or target)â of the rate of return for the firmâs equity. Hence, if the stock returns actually reach this rate, it is good enough already.

e) Capital budgeting is to determine the best capital structure for the firm in raising capital from the capital market.

f) To calculate the weighted average cost of capital is to assume that expected rates of return from different sources are evaluated according to relative contributed proportions on entire capitalization without references to where and who contributed the fund.

g) The yield to maturity of the corporate bond is always the expected rate for return for bondholders, regardless of their intended holding horizons of the bonds.

I need help proof reading my assignment please, thank you in advance.

Cost of Debt

The cost of debt is the effective rate that a company pays on its total debt.

As a company acquires debt through various bonds, loans and other forms of debt, the cost of debt is a useful metric. It gives an idea as to the overall rate being paid by the company to use debt financing. This measure is also useful because it gives investors an idea as to the riskiness of the company compared with others. The higher the cost of debt, the higher the risk.

1. Cost of debt (before tax) = Corporate Bond rate of companyâs bond rating.

Pepsico 2.75% = 2.75%

Current cost of Debt as of February 17th 2014 = 2.75%

2. Current tax rate

In 2013 PepsiCoâs tax rate was = 23.66%

2013 PepsiCo averaged tax rate of 23.66%

3. Cost of Debt (After Tax) = (Cost of Debt Before Tax) (1 â Tax Rate)

The effective rate that a company pays on its current debt after tax.

.0275 x (1 â .2366) = Cost of debt after tax

The cost of debt after tax for PepsiCo is 2.10%

Cost of Equity or R Equity = Risk Free Rate + Beta Equity (Average Market Return â Risk Free Rate)

The cost of equity is the return a firm theoretically pays to its equity investors to compensate for the risk they undertake by investing in their company.

Risk Free Rate = U.S. 10-year bond = 2.74%

Average Market Return 1950 â 2014 = 7%

Beta = PepsiCoâs Beta = 0.37

Risk Free Rate + Beta Equity (Average Market Return â Risk Free Rate)

2.74 + 0.37 (7- 2.74)

2.74 + 0.37 x 4.26

2.74 + 1.58 = 4.31%

Currently, PepsiCoâs has a Cost of Equity or R Equity of 4.31%, so investors should expect to get a return of 4.31% per-year average over the long term on their investment to compensate for the risk they undertake by investing in this company.

Weighted Average Cost of Capital or WACC calculation

The WACC calculation is a calculation of a companyâs cost of capital in which each category of capital is equally weighted. All capital sources such as common stock, preferred stock, bonds and all other long-term debt are included in this calculation.

As the WACC of a firm increases, and the beta and rate of return on equity increases, this is an indicator of a decrease in valuation and a higher risk. By taking the weighted average, we can see how much interest the company has to pay for every dollar it finances. For this calculation, you will need to know the following listed below:

Tax Rate = 23.66%

Cost of Debt (before tax) or R debt = 2.75%

Cost of Equity or R equity = 4.31%

Debt (Total Liabilities) for 2013 TTM or D = $53.069 billion

Stock Price = $78.09 (Feb. 17th, 2014)

Outstanding Shares = 1.55 billion

Equity = Stock price x Outstanding Shares or E = $121.04 billion

Debt + Equity or D+E = $174.109 billion

WACC = R = (1 â Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 â Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 â .2366) x .0275 x ($53.069 /$174.109) + .0431 ($121.04 /$174.109)

.7634x .0275 x .3048 + .0431 x .6972

.0064 + .03

= 3.64%

Based on the calculations above, we can conclude that PepsiCo pays 3.64% on every dollar that it finances, or 3.64% cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0673 plus the cost of the investment for the investment to be feasible for the company.

Understanding the WACC of a company is important because securities analysts employ WACC all the time when valuing and selecting investments. In discounted cash flow analysis, for instance, WACC is used as the discount rate applied to future cash flows for deriving a businessâs net present value.

Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. Letâs say a company produces a return of 20% and has a WACC of 11%. That means that for every dollar the company invests into capital, the company is creating nine cents of value. By contrast, if the companyâs return is less than WACC, the company is shedding value, which indicates that investors should put their money elsewhere.

FINS1613 Lecture Notes - Lecture 7: Risk-Free Interest Rate, Risk Premium, Capital Asset Pricing Model

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