PPT Module 12 Cost of Capital

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1 Module 12: Cost of Capital Learning Objectives: § Explain the basics of valuation ( LO1 ) § Explain and estimate the: Cost of equity capital: r e ( LO2 ) Cost of debt capital: r d ( LO3 ) Weighted average cost of capital (WACC): r w ( LO4 ) § Explain and describe the limitations of the dividend discount model ( LO5,6 ) 1
2 Learning Objective Explain the basics of valuation ( LO1 ) 2
3 Basics of Valuation § We can use valuation techniques to: § Compare our stock-price estimate (based on our assumptions and estimates) to the observed trading price and then decide whether to buy, sell, or hold the stock § Set a share price in an initial public offering § Determine the current price of a bond or other financial instrument
4 Valuation Model Components TWO COMPONENTS § Future Payoffs § Equity: depends on what model you use (dividends, profit, cash flows) § Debt: annuity payments and future lump sum (face value) § Cost of Capital § Represents the return the investor expects on their investment § Based on the perceived risk of the investment 4
5 Estimating Cost of Capital 5 § Investors who price financial instruments, expect to recover two costs: the time value of money and the cost of risk § The risk-adjusted discount rate is exactly equal to the investor's required rate of return or cost of capital Foregone interest from investing in an instrument with future payoffs Compensation for bearing the risk associated with uncertain payoffs These two components make up the RISK-ADJUSTED DISCOUNT RATE
6 Using Discount Rates § Cost of debt capital ü Used for payoffs to debtholders § Cost of equity capital ü Used for payoffs to equity holders § Weighted average cost of capital ü Used for payoffs to the entire firm 6
7 Intrinsic Value § Defined as the economic value of the company assuming that future actual payoffs are known 7
8 Diversifiable Risk § Refers to risks that can be diversified away by investors § One way to diversify, is to hold a " market portfolio "—meaning to hold all stocks available in the market § The underlying assumption is that the market portfolio diversifies away all the risks that are diversifiable and the remaining risk in a market portfolio is "non-diversifiable" Do investors expect to get compensated for Diversifiable Risk ? - Models used to estimate cost of capital assume that investors are only concerned with non-diversifiable risk, and are willing to accept diversifiable risk without compensation 8
9 Note: § Diversifiable Risk = Unsystematic Risk = Idiosyncratic Risk § Non-Diversifiable Risk = Systematic Risk 9
10 Learning Objective Explain and estimate the cost of equity capital ( LO2 ) 10
11 Cost of Equity Capital Using the Capital Asset Pricing Model 11 § The CAPM estimates a company's expected return, or cost of equity capital (r e ), as follows: r e = r f + [ b × (r m - r f )] r e = risk-free rate Commonly estimated with US treasury notes (r m - r f )= market risk premium Historically fluctuates between 4 - 8% b = market beta The sensitivity of the asset's return to the overall market
12 Interpreting Market Beta The higher the risk an investor is willing to accept, the higher the expected return. -1 +1 0 Stock price will change contrary to a change in the overall market. Stock price will change by a smaller percent with a change in the overall market. Stock price will change by a larger percent with a change in the overall market. 12
13 Multi - Factor Models § Developed to compute risk-adjusted returns § Used to compute cost of equity capital § Risk factors based on fundamental analysis § Internal risk factors § Such as operating leverage, financial leverage, effectiveness of internal control § External risk factors § Such as exchange risk, political risk, supply chain risk, industry competition 13
14 Practice Problem: P12 - 40 14 f. Compute 3M's cost of equity capital r e = r f + [ b × (r m - r f )] = 2.1% + [1.14 x (5%)] = 7.8%
15 Learning Objective Explain and estimate the cost of debt capital ( LO3 ) 15
Cost of Debt Capital § The cost of debt capital (rd) is the market rate on debt instruments , calculated as: r d = Pretax borrowing rate × (1 - tax rate) 16
17 Cost of Debt Capital § Borrowing rate depends on a company's perceived level of risk (using credit analysis) § Debt ratings become important in determining the cost of debt § Factors considered by lenders § Liquidity § Solvency § Coverage 17
18 Calculating After - Tax Cost of Debt § Multiplying by (1 - tax rate) acknowledges the tax savings from the interest expense deduction § Ideally, we would use the marginal tax rate as we want to know the change in taxes if the debt level changed § However, the marginal tax rate is unobservable and we use the statutory tax rate of 21% plus or minus state statutory rates net of any federal benefits
19 Practice Problem: P12 - 40 19
20 3M Balance Sheet 20 A) Market Cap = Stock price X Shares Outstanding = $190.54 x 576,575,168 = 109.86B Ycharts reports: $108.47B B) Compute BV of Long Term Debt = $1,211M + 13,411M = $14.622 B
21 Practice Problem: P12 - 40 21 c. Compute MV of 3M's long-term debt Recall: Therefore: Market Value of Debt = Firm Value - Equity Value = $119.84B - $108.46 = $11.38B
22 Practice Problem: P12 - 40 22 d. Why is book value ($14.622B from part b) and market value ($11.38B from part c) different? § Ychart might be including or excluding different items § Perhaps differences due to inclusion of other liabilities (e.g, such as lease obligations), calculation of debt, or exclusion of short-term borrowings. § Accounting numbers are based on historical cost, therefore, MV & BV of debt could differ
23 Practice Problem: P12 - 40 23 c. Compute the Cost of Debt Recall: Cost of Debt Capital = 2.07% x (1 - 21%) = 1.64%
24 Learning Objective Explain and estimate the weighted average cost of capital, WACC ( LO4 ) 24
Weighted Average Cost of Capital § The nature of the future payoffs dictates the discount rate we use to compute their present value § When valuing a debt instrument we use the cost of debt capital and when valuing equity instruments we use the cost of equity capital § Some valuation models, such as the discounted free cash flow and the residual operating income models, assume the payoffs are distributed to both equity holders and debt holders § For these models, the appropriate discount rate is a weighted average of the cost of debt capital and the cost of equity capital
26 Weighted Average Cost of Capital (WACC) § Calculation of WACC: § Where § IV Firm is the intrinsic value of the company § IV Debt is the intrinsic value of company debt § IV Equity is the intrinsic value of company equity § Because intrinsic values are unobservable, we use market value of equity and market value of debt (or book value when market value is difficult to determine) 26
27 Practice Problem: P12 - 40 27 c. Compute the weighted average cost of capital (using Market Cap from Ychart): Recall: Enterprise Value/Total Firm Value Market Cap from Ychart Cost of Debt Cost of Equity MV of Debt
28 Learning Objective § Explain and describe the limitations of the dividend discount model ( LO5,6 ) 28
29 § Equates current stock price to the present value of all future expected dividends § Two methods to forecast future dividends through infinity § Perpetuity method § final payment: divide by r e and discount back to time 0 § Constant growth method § final payment: divide by ( r e - g ) and discount back to time 0 Dividend Discount Model Framework 29
30 DDM with Constant Perpetuity Example Midwest Corp. has an expected dividend for 2 years of $1.50, followed by a $2.25 dividend in Year 3, and $2.75 per year thereafter . The cost of equity capital is estimated at 7.6%. What is today's intrinsic value? = $1.39 + $1.30 + $1.81 + $29.05 = $33.55 ($2.75 / 0.076) (1.076) 3 + Perpetuity IV 0 = $1.50 1.076 $1.50 (1.076) 2 + $2.25 (1.076) 3 + Years 1, 2, and 3 30
31 DDM with Increasing Perpetuity Example Midwest Corp. has an expected dividend for 2 years of $1.50, followed by a $2.25 dividend in Year 3, and $2.75 in Year 4 with a growth of 2% per year thereafter . The cost of equity capital is estimated at 7.6%. What is today's intrinsic value? = $1.39 + $1.30 + $1.81 + $39.42 = $43.92 [$2.75 / (0.076 - 0.02)] (1.076) 3 + Perpetuity IV 0 = $1.50 1.076 $1.50 (1.076) 2 + $2.25 (1.076) 3 + Years 1, 2, and 3 31
32 Issues in Applying the Dividend Discount Model § A large percentage of publicly traded companies do not issue dividends § Zero payout may continue indefinitely § Some companies have unusually high dividend payouts given their profit levels § Sustaining may not be possible § It is difficult to create accurate dividend forecasts, in general 32
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