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1
CHAPTER 8
Stocks, Stock Valuation, and Stock Market Equilibrium
Professor CambryOctober 7, 2010
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Topics in Chapter
Features of common stock Determining common stock values Efficient markets Preferred stock
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Common Stock: Owners, Directors, and Managers
Represents ownership. Ownership implies control. Stockholders elect directors. Directors hire management. Since managers are “agents” of
shareholders, their goal should be: Maximize stock price.
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Classified Stock
Classified stock has special provisions.
Could classify existing stock as founders’ shares, with voting rights but dividend restrictions.
New shares might be called “Class A” shares, with voting restrictions but full dividend rights.
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Tracking Stock The dividends of tracking stock are tied
to a particular division, rather than the company as a whole. Investors can separately value the divisions. Its easier to compensate division managers
with the tracking stock. But tracking stock usually has no voting
rights, and the financial disclosure for the division is not as regulated as for the company.
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Initial Public Offering (IPO)
A firm “goes public” through an IPO when the stock is first offered to the public.
Prior to an IPO, shares are typically owned by the firm’s managers, key employees, and, in many situations, venture capital providers.
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Seasoned Equity Offering (SEO)
A seasoned equity offering occurs when a company with public stock issues additional shares.
After an IPO or SEO, the stock trades in the secondary market, such as the NYSE or Nasdaq.
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Different Approaches for Valuing Common Stock
Dividend growth model Using the multiples of comparable
firms Free cash flow method (covered in
Chapter 15)
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Stock Value = PV of Dividends
What is a constant growth stock?
One whose dividends are expected togrow forever at a constant rate, g.
P0 =^
(1+rs)1 (1+rs)2 (1+rs)3 (1+rs)∞
D1 D2 D3 D∞+ + +…+
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For a constant growth stock:
D1 = D0(1+g)1
D2 = D0(1+g)2
Dt = D0(1+g)t
If g is constant and less than rs, then:
P0 = ^ D0(1+g)
rs - g=
D1
rs - g
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Dividend Growth and PV of Dividends: P0 = ∑(PVof Dt)
$
0.25
Years (t)
Dt = D0(1 + g)t
PV of Dt =Dt
(1 + r)t
If g > r, P0 = ∞ !
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Required rate of return: beta = 1.2, rRF = 7%, and RPM = 5%.
rs = rRF + (RPM)bFirm
= 7% + (5%) (1.2)= 13%.
Use the SML to calculate rs:
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Projected Dividends
D0 = 2 and constant g = 6%
D1 = D0(1+g) = 2(1.06) = 2.12 D2 = D1(1+g) = 2.12(1.06) =
2.2472 D3 = D2(1+g) = 2.2472(1.06) =
2.3820
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Expected Dividends and PVs (rs = 13%, D0 = $2, g = 6%)
0 1
2.2472
2
2.3820
3g=6% 4
1.87611.75991.6508
13%
2.12
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Intrinsic Stock Value: D0 = 2.00, rs = 13%, g = 6%.
Constant growth model:
= = $30.29.0.13 - 0.06
$2.12 $2.12
0.07
P0 = ^ D0(1+g)
rs - g=
D1
rs - g
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Expected value one year from now:
D1 will have been paid, so expected dividends are D2, D3, D4 and so on.
P1 = ^ D2
rs - g=
$2.2427
0.07= $32.10
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Expected Dividend Yield and Capital Gains Yield (Year 1)
Dividend yield = = = 7.0%.$2.12
$30.29
D1
P0
CG Yield = =P1 - P0
^
P0
$32.10 - $30.29
$30.29
= 6.0%.
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Total Year-1 Return
Total return = Dividend yield + Capital gains yield.
Total return = 7% + 6% = 13%. Total return = 13% = rs. For constant growth stock:
Capital gains yield = 6% = g.
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Rearrange model to rate of return form:
Then, rs = $2.12/$30.29 + 0.06= 0.07 + 0.06 = 13%.
^
P0 = ^ D1
rs - gto
D1
P0
rs
^= + g.
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If g = 0, the dividend stream is a perpetuity.
2.00 2.002.00
0 1 2 3rs=13%
P0 = = = $15.38.PMT
r
$2.00
0.13^
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Expected Dividend Yield and Capital Gains Yield (t = 0)
CG Yield = 13.0% - 4.8% = 8.2%.
Dividend yield = = = 4.8%.$2.60
$54.11
D1
P0
At t = 0:
(More…)
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Expected Dividend Yield and Capital Gains Yield (t = 4) During nonconstant growth, dividend
yield and capital gains yield are not constant.
If current growth is greater than g, current capital gains yield is greater than g.
After t = 3, g = constant = 6%, so the t = 4 capital gains gains yield = 6%.
Because rs = 13%, the t = 4 dividend yield = 13% - 6% = 7%.
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Is the stock price based onshort-term growth?
The current stock price is $54.11. The PV of dividends beyond year 3
is $46.11 (P3 discounted back to t = 0).
The percentage of stock price due to “long-term” dividends is:
= 85.2%.$46.11$54.11
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Intrinsic Stock Value vs. Quarterly Earnings
Sometimes changes in quarterly earnings are a signal of future changes in cash flows. This would affect the current stock price.
Sometimes managers have bonuses tied to quarterly earnings.
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Suppose g = 0 for t = 1 to 3, and then g is a constant 6%.
0
1.76991.56631.3861
20.9895
1 2 3 4rs=13%
25.7118
g = 0% g = 0% g = 0% g = 6%
2.00 2.00 2.00 2.12
2.12P30.07
30.2857
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Dividend Yield and Capital Gains Yield (t = 0)
Dividend Yield = D1 / P0
Dividend Yield = $2.00 / $25.72 Dividend Yield = 7.8%
CGY = 13.0% - 7.8% = 5.2%.
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Dividend Yield and Capital Gains Yield (t = 3)
Now have constant growth, so:
Capital gains yield = g = 6%
Dividend yield = rs – g Dividend yield = 13% - 6% = 7%
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If g = -6%, would anyone buy the stock? If so, at what price?
Firm still has earnings and still paysdividends, so P0 > 0:^
= = = $9.89.$2.00(0.94)
0.13 - (-0.06)
$1.88
0.19
P0 = ^ D0(1+g)
rs - g=
D1
rs - g
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Annual Dividend and Capital Gains Yields
Capital gains yield = g = -6.0%.
Dividend yield = 13.0% - (-6.0%)= 19.0%.
Both yields are constant over time, with the high dividend yield (19%) offsetting the negative capital gains yield.
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Using Stock Price Multiples to Estimate Stock Price Analysts often use the P/E multiple
(the price per share divided by the earnings per share).
Example: Estimate the average P/E ratio of
comparable firms. This is the P/E multiple.
Multiply this average P/E ratio by the expected earnings of the company to estimate its stock price.
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Using Entity Multiples The entity value (V) is:
the market value of equity (# shares of stock multiplied by the price per share)
plus the value of debt. Pick a measure, such as EBITDA, Sales,
Customers, Eyeballs, etc. Calculate the average entity ratio for a
sample of comparable firms. For example, V/EBITDA V/Customers
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Using Entity Multiples (Continued) Find the entity value of the firm in
question. For example, Multiply the firm’s sales by the V/Sales
multiple. Multiply the firm’s # of customers by the
V/Customers ratio The result is the total value of the firm. Subtract the firm’s debt to get the total
value of equity. Divide by the number of shares to get
the price per share.
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Problems with Market Multiple Methods It is often hard to find comparable firms. The average ratio for the sample of
comparable firms often has a wide range. For example, the average P/E ratio might be
20, but the range could be from 10 to 50. How do you know whether your firm should be compared to the low, average, or high performers?
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Preferred Stock
Hybrid security. Similar to bonds in that preferred
stockholders receive a fixed dividend which must be paid before dividends can be paid on common stock.
However, unlike bonds, preferred stock dividends can be omitted without fear of pushing the firm into bankruptcy.
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Expected return, given Vps = $50 and annual dividend = $5
Vps = $50 =$5
rps
^
rps
$5
$50
^= = 0.10 = 10.0%
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Why are stock prices volatile?
rs = rRF + (RPM)bi could change. Inflation expectations Risk aversion Company risk
g could change.
P0 = ^ D1
rs - g
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Consider the following situation.
D1 = $2, rs = 10%, and g = 5%:
P0 = D1 / (rs-g) = $2 / (0.10 - 0.05) = $40.
What happens if rs or g change?
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Stock Prices vs. Changes in rs and g
g
rs 4% 5% 6%
9% 40.00 50.00 66.67
10% 33.33 40.00 50.00
11% 28.57 33.33 40.00
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Are volatile stock prices consistent with rational pricing?
Small changes in expected g and rs cause large changes in stock prices.
As new information arrives, investors continually update their estimates of g and rs.
If stock prices aren’t volatile, then this means there isn’t a good flow of information.
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What is market equilibrium? In equilibrium, stock prices are
stable. There is no general tendency for people to buy versus to sell.
The expected price, P, must equal the actual price, P. In other words, the fundamental value must be the same as the price.
(More…)
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CHAPTER 10
The Cost of Capital
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Topics in Chapter
Cost of Capital Components Debt Preferred Common Equity
WACC
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What types of long-term capital do firms use?
Long-term debt Preferred stock Common equity
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Capital Components Capital components are sources of
funding that come from investors. Accounts payable, accruals, and
deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital.
We do adjust for these items when calculating the cash flows of a project, but not when calculating the cost of capital.
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Before-tax vs. After-tax Capital Costs Tax effects associated with
financing can be incorporated either in capital budgeting cash flows or in cost of capital.
Most firms incorporate tax effects in the cost of capital. Therefore, focus on after-tax costs.
Only cost of debt is affected.
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Historical (Embedded) Costs vs. New (Marginal) Costs
The cost of capital is used primarily to make decisions which involve raising and investing new capital. So, we should focus on marginal costs.
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Cost of Debt Method 1: Ask an investment
banker what the coupon rate would be on new debt.
Method 2: Find the bond rating for the company and use the yield on other bonds with a similar rating.
Method 3: Find the yield on the company’s debt, if it has any.
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A 15-year, 12% semiannual bond sells for $1,153.72. What’s rd?
60 60 + 1,00060
0 1 2 30i = ?
-1,153.72
...
30 -1153.72 60 1000
5.0% x 2 = rd = 10%
N I/YR PV FVPMT
INPUTS
OUTPUT
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Component Cost of Debt
Interest is tax deductible, so the after tax (AT) cost of debt is: rd AT = rd BT(1 - T) rd AT= 10%(1 - 0.40) = 6%.
Use nominal rate. Flotation costs small, so ignore.
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Cost of preferred stock: PP = $113.10; 10%Q; Par = $100; F = $2.
Use this formula:
rps =Dps
Pps (1-F)=
0.1($100)
$116.95(1-0.05)
=$10
$111.10
= 0.090=9.0%
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Time Line of Preferred
2.50 2.502.50
0 1 2 ∞rps=?
-111.1
...
$111.10=
DQ
rPer
= $2.50
rPer
rPer =$2.50
$111.10= 2.25%; rps(Nom) = 2.25%(4) = 9%
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Note:
Flotation costs for preferred are significant, so are reflected. Use net price.
Preferred dividends are not deductible, so no tax adjustment. Just rps.
Nominal rps is used.
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Is preferred stock more or less risky to investors than debt?
More risky; company not required to pay preferred dividend.
However, firms want to pay preferred dividend. Otherwise, (1) cannot pay common dividend, (2) difficult to raise additional funds, and (3) preferred stockholders may gain control of firm.
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Why is yield on preferred lower than rd?
Corporations own most preferred stock, because 70% of preferred dividends are nontaxable to corporations.
Therefore, preferred often has a lower B-T yield than the B-T yield on debt.
The A-T yield to investors and A-T cost to the issuer are higher on preferred than on debt, which is consistent with the higher risk of preferred.
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Example:
rps = 9% rd = 10% T = 40%
rps, AT = rps - rps (1 - 0.7)(T)
= 9% - 9%(0.3)(0.4) = 7.92%
rd, AT = 10% - 10%(0.4) = 6.00%
A-T Risk Premium on Preferred = 1.92%
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What are the two ways that companies can raise common equity?
Directly, by issuing new shares of common stock.
Indirectly, by reinvesting earnings that are not paid out as dividends (i.e., retaining earnings).
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Why is there a cost for reinvested earnings?
Earnings can be reinvested or paid out as dividends.
Investors could buy other securities, earn a return.
Thus, there is an opportunity cost if earnings are reinvested.
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Cost for Reinvested Earnings (Continued)
Opportunity cost: The return stockholders could earn on alternative investments of equal risk.
They could buy similar stocks and earn rs, or company could repurchase its own stock and earn rs. So, rs, is the cost of reinvested earnings and it is the cost of equity.
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Three ways to determine the cost of equity, rs:
1. CAPM: rs = rRF + (rM -
rRF)b
= rRF + (RPM)b.
2. DCF: rs = D1/P0 + g.
3. Own-Bond-Yield-Plus-Risk Premium:
rs = rd + Bond RP.
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CAPM Cost of Equity: rRF = 7%, RPM = 6%, b = 1.2.
rs = rRF + (rM - rRF )b.
= 7.0% + (6.0%)1.2 = 14.2%.
61
Issues in Using CAPM
Most analysts use the rate on a long-term (10 to 20 years) government bond as an estimate of rRF.
More…
62
Issues in Using CAPM (Continued)
Most analysts use a rate of 5% to 6.5% for the market risk premium (RPM)
Estimates of beta vary, and estimates are “noisy” (they have a wide confidence interval).
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DCF Cost of Equity, rs: D0 = $4.19; P0 = $50; g = 5%.
rs =
D1
P0
+ g =D0(1+g)
P0
+ g
= $4.19(1.05)
$50+ 0.05
= 0.088 + 0.05= 13.8%
64
Estimating the Growth Rate
Use the historical growth rate if you believe the future will be like the past.
Obtain analysts’ estimates: Value Line, Zack’s, Yahoo.Finance.
Use the earnings retention model, illustrated on next slide.
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Earnings Retention Model
Suppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue.
What’s the expected future g?
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Earnings Retention Model (Continued) Growth from earnings retention model:
g = (Retention rate)(ROE) g = (1 - payout rate)(ROE) g = (1 – 0.65)(15%) = 5.25%.
This is close to g = 5% given earlier. Think of bank account paying 15% with retention ratio = 0. What is g of account balance? If retention ratio is 100%, what is g?
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Could DCF methodology be applied if g is not constant?
YES, nonconstant g stocks are expected to have constant g at some point, generally in 5 to 10 years.
But calculations get complicated. See the “Web 10B” worksheet in the file “FM12 Ch 10 Tool Kit.xls”.
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The Own-Bond-Yield-Plus-Risk-Premium Method: rd = 10%, RP = 4%.
rs = rd + RP rs = 10.0% + 4.0% = 14.0%
This RP CAPM RPM. Produces ballpark estimate of rs.
Useful check.
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What’s a reasonable final estimate of rs?
Method Estimate
CAPM 14.2%
DCF 13.8%
rd + RP 14.0%
Average 14.0%
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Determining the Weights for the WACC
The weights are the percentages of the firm that will be financed by each component.
If possible, always use the target weights for the percentages of the firm that will be financed with the various types of capital.
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Estimating Weights for the Capital Structure
If you don’t know the targets, it is better to estimate the weights using current market values than current book values.
If you don’t know the market value of debt, then it is usually reasonable to use the book values of debt, especially if the debt is short-term. (More..
.)
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Estimating Weights (Continued)
Suppose the stock price is $50, there are 3 million shares of stock, the firm has $25 million of preferred stock, and $75 million of debt.
(More...)
73
Estimating Weights (Continued)
Vce = $50 (3 million) = $150 million.
Vps = $25 million. Vd = $75 million. Total value = $150 + $25 + $75 =
$250 million.
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Estimating Weights (Continued)
wce = $150/$250 = 0.6 wps = $25/$250 = 0.1 wd = $75/$250 = 0.3
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What’s the WACC?
WACC = wdrd(1 - T) + wpsrps + wcers
WACC = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
WACC = 1.8% + 0.9% + 8.4% = 11.1%.
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What factors influence a company’s WACC?
Market conditions, especially interest rates and tax rates.
The firm’s capital structure and dividend policy.
The firm’s investment policy. Firms with riskier projects generally have a higher WACC.
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Is the firm’s WACC correct for each of its divisions?
NO! The composite WACC reflects the risk of an average project undertaken by the firm.
Different divisions may have different risks. The division’s WACC should be adjusted to reflect the division’s risk and capital structure.
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The Risk-Adjusted Divisional Cost of Capital
Estimate the cost of capital that the division would have if it were a stand-alone firm.
This requires estimating the division’s beta, cost of debt, and capital structure.
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Pure Play Method for Estimating Beta for a Division or a Project
Find several publicly traded companies exclusively in project’s business.
Use average of their betas as proxy for project’s beta.
Hard to find such companies.
80
Accounting Beta Method for Estimating Beta
Run regression between project’s ROA and S&P index ROA.
Accounting betas are correlated (0.5 – 0.6) with market betas.
But normally can’t get data on new projects’ ROAs before the capital budgeting decision has been made.
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Divisional Cost of Capital Using CAPM
Target debt ratio = 10%. rd = 12%. rRF = 7%. Tax rate = 40%. betaDivision = 1.7. Market risk premium = 6%.
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Divisional Cost of Capital Using CAPM (Continued)
Division’s required return on equity:rs = rRF + (rM – rRF)bDiv.
rs = 7% + (6%)1.7 = 17.2%.
WACCDiv. = wd rd(1 – T) + wc rs
= 0.1(12%)(0.6) + 0.9(17.2%)
= 16.2%.
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Division’s WACC vs. Firm’s Overall WACC?
Division WACC = 16.2% versus company WACC = 11.1%.
“Typical” projects within this division would be accepted if their returns are above 16.2%.
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What are the three types of project risk?
Stand-alone risk Corporate risk Market risk
85
How is each type of risk used? Stand-alone risk is easiest to
calculate. Market risk is theoretically best in
most situations. However, creditors, customers,
suppliers, and employees are more affected by corporate risk.
Therefore, corporate risk is also relevant.
86
A Project-Specific, Risk-Adjusted Cost of Capital
Start by calculating a divisional cost of capital.
Use judgment to scale up or down the cost of capital for an individual project relative to the divisional cost of capital.
87
Costs of Issuing New Common Stock
When a company issues new common stock they also have to pay flotation costs to the underwriter.
Issuing new common stock may send a negative signal to the capital markets, which may depress stock price.
88
Cost of New Common Equity: P0=$50, D0=$4.19, g=5%, and F=15%.
re =D0(1 + g)
P0(1 - F)+ g
= $4.19(1.05)$50(1 – 0.15)
+ 5.0%
= $4.40
$42.50
+ 5.0% = 15.4%
89
Cost of New 30-Year Debt: Par=$1,000, Coupon=10% paid annually, and F=2%.
Using a financial calculator: N = 30 PV = 1000(1-.02) = 980 PMT = -(.10)(1000)(1-.4) = -60 FV = -1000
Solving for I: 6.15%
90
Comments about flotation costs: Flotation costs depend on the risk of the
firm and the type of capital being raised.
The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small.
We will frequently ignore flotation costs when calculating the WACC.
91
Four Mistakes to Avoid
Current vs. historical cost of debt Mixing current and historical
measures to estimate the market risk premium
Book weights vs. Market Weights Incorrect cost of capital
components
See next slides for details.
(More ...)
92
Current vs. Historical Cost of Debt
When estimating the cost of debt, don’t use the coupon rate on existing debt.
Use the current interest rate on new debt.
(More ...)
93
Estimating the Market Risk Premium When estimating the risk premium for
the CAPM approach, don’t subtract the current long-term T-bond rate from the historical average return on common stocks.
For example, if the historical rM has been about 12.2% and inflation drives the current rRF up to 10%, the current market risk premium is not 12.2% - 10% = 2.2%!
(More ...)
94
(More...)
Estimating Weights Use the target capital structure to
determine the weights. If you don’t know the target weights,
then use the current market value of equity, and never the book value of equity.
If you don’t know the market value of debt, then the book value of debt often is a reasonable approximation, especially for short-term debt.
95
Capital components are sources of funding that come from investors.
Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the WACC.
We do adjust for these items when calculating the cash flows of the project, but not when calculating the WACC.
