Required
Return versus Cost of Capital The cost of capital is the cost of raising
the funds necessary to finance an investment project; thus, it can be thought
of as the minimum acceptable rate of return on that project, i.e., the required
return
(52.0K)
. From a mathematical standpoint, the required return
is the appropriate discount rate for use in computing the NPV of
a project. What is the NPV of a project whose IRR just equals the cost
of capital? CONCEPT CHECK
Financial
Policy and Cost of Capital The firm's financial policies -- i.e., the
mix of debt and equity used -- will be taken as a given for the present
discussion. However, regardless of the particular capital
structure (KEY TERM) used, the overall cost of capital will be a mixture
of the returns needed to compensate the firm's creditors and stockholders.
The Cost of Equity
(51.0K)
The cost of equity is generally the most difficult figure to obtain, since it is not directly observable. Some managers and analysts obtain estimates from commercial sources.
Implementing
the Approach is accomplished by rearranging the variables of the constant
growth valuation model from the chapter on equity valuation. The model indicates
that, under certain condition, the current market price (P0) of
a share of common stock is equal to D1/(R- g). What do the symbols
R and g represent? Then, solving for R (which we now rename RE),
we find that it is equal to D1/P0 + g. CONCEPT CHECK
Estimating
g is generally done using as starting points either (1) historical growth
rates, or (2) the earnings
forecasts of professional security analysts.
Advantages
and Disadvantages
(52.0K)
of the Approach are many -- on the upside,
it's easy to obtain both historical estimates and analysts' estimates.
On the other hand, however, the approach is useless for firms that don't
pay dividends (at this writing Microsoft
has yet to pay a dividend, for example), and even for firms
that do, the estimation process is another form of forecasting, which is
always difficult.
Implementing
the Approach requires use of the CAPM, which means obtaining values for three
variables: the risk-free
rate (KEY TERM), the market
risk premium (KEY TERM), and the appropriate beta
coefficient (KEY TERM). The required return RE, is equal to Rf +
bE X (RM - Rf).
Advantages
and Disadvantages of the Approach
(53.0K)
This approach adjusts explicitly
for risk (unlike the Dividend Growth Model approach), but requires that
we estimate the market risk premium and the beta coefficient. (The latter
is obtainable from many published sources, as well as on the Internet.)
The
Costs of Debt and Preferred Stock
The
Cost of Debt
(53.0K)
is the returncreditors demand in
order to be willing to purchase new debt from the firm. Denoted RD,
the cost of debt is actually the Yield-to-Maturity
(KEY TERM) computed in an earlier chapter.
The
Cost of Preferred Stock
(51.0K)
is found using the following perpetuity
model: RP = D/P0. We assume the dividend on preferred
stock is constant and will continue forever.
The
Capital Structure Weights The total market value of the firm, V, is
equal to the sum of the market value of the firm's outstanding debt, D,
and the market value of its outstanding equity, E. In other word, V = D
+ E. Thus, the percentage of debt used equal D/V, and the percentage of
equity used is E/V. D/V and E/V are the firm's capital
structure weights
(53.0K)
.
Taxes
and the Weighted Average Cost of Capital
(52.0K)
Recall that
in order to evaluate a project we begin by estimating its incremental,
after-tax cash flows. Since we are discounting after-tax cash flows,
it makes sense to do so with an after-tax cost of capital. Thus, we need
to recognize the deductibility of interest paid by finding the after-tax
cost of debt (which, of course, equals RD X (1
- TC). Thus, the WACC equals: (E/V) X RE +
(D/V) X RDX (1 - TC). Key
Concept: The WACC is the overall
return the firm must earn on its existing assets to maintain the value
of the stock.
Solving
the Warehouse Problem and Similar Capital Budgeting Problems
The
SML and the WACC Graphing expected return against risk, the SML is
an upward-sloping line and the WACC is a horizontal line. Why? CONCEPT CHECK A
firm that uses the WACC to evaluate all projects, regardless of their respective
risks, will overvalue projects that are riskier than the firm and undervalue
projects that are less risky than the firm.
Divisional
Cost of Capital Just as the required return of each project is a positive
function of its risk, the required return of a division (i.e., the divisional
cost of capital) is a positive function of the division's risk.
The
Pure Play Approach
(51.0K)
In order to obtain the appropriate
discount rate when the returns on a project (or division) are not observable,
we must use as a proxy (or "pure play") the required return
on assets of similar risk whose discount rate is estimable.
The
Subjective Approach
(52.0K)
Because of the difficulty in establishing
discount rates, many firms group projects into categories based on the
level of uncertainty of their cash flows. Successively higher-risk categories
are assigned higher discount rates relative to the firm WACC, and lower-risk
categories are assigned lower discount rates.
(52.0K)