Reading 36 LOS's

Question 1

LOS 36a: Calculate and interpret the weighted average cost of capital (WACC) of a company

Answer 1

To raise capital, a company can either issue equity or debt. An instrument that is used to obtain financing is called a component, and each component has a different required rate of return, which is known as the components cost of capital. The weighted average of the costs of various components used by the company to finance its operations is known as the WACC or the marginal cost of capital (MCC).

WACC is the expected rate of return that investors demand for financing an average risk investment of the company

• WACC = (w_d)(r_d)(1-t) + (w_p)(r_p) + (w_e)(r_e)

Where:

• w_d= proportion of debt that they company uses when it raises new funds
• r_d= before-tax marginal cost of debt
• t= company’s marginal tax rate
• w_p= Proportion of preferred stock that the company uses when it raises new
• r_p= marginal cost of preferred stock
• w_e= proportion of equity that the company uses when it raises new funds
• r_e= Maginal cost of equity

Question 2

LOS 36b: Describe how taxes affect the cost of capital from different capital sources

Answer 2

Tax savings are only realized on payments to holders of debt instruments. Payments to preferred and common stock holders are not expensed on the income statement and do not result in tax savings.

So whatever interest expense a company incurs, can be multiplied by the tax rate, to determine the tax shield. The tax shield is subtracted from the interest expense to determine how much interest expense actually reduces net income, reducing the cost of capital

Question 3

LOS 36c: Explain alternative methods of calculating the weights used in the WACC, including the use of the company’s target capital structure

Answer 3

The target capital structure is the capital structure that the company aims to maintain. The weights used in the calculation of WACC are the proportions of debt, preferred stock, and equity that the firm hopes to achieve and maintain in its capital structure over time. A simple way to transform a debt to equity ratio (D/E) into a weight is to simply divide the ratio by (1 + D/E).

If information about the target capital structure is not easily available, we can use the weights in the company’s current capital structure. The weights of various components should be based on market values

Question 4

LOS 36d: Explain how the marginal cost of capital and the investment opportunity schedule are used to determine the optimal capital budget

Answer 4

A company’s MCC increases as it raises additional capital. This is because most firms must pay a higher cost to obtain increasing amounts of capital.

The profitability of a company’s investment opportunities decreases as the company makes additional investments. The company prioritizes investments in projects with the highest IRRs. AS more resources are invested in the most rewarding projects, remaining opportunities offer lower and lower IRRs. This fact is represented by an investment opportunity schedule (IOS) that is downward sloping

The optimal capital budget occurs at the point where the marginal cost of capital interesects the investment opportunity schedule

• The company should raise capital and undertake all projects to the left of this intersection, because these projects enhance shareholder wealth given the cost of financing them
• To raise capital in excess of the optimal capital budget, the firm will be required to incur a cost of capital that is greater than the return on available investments

Question 5

LOS 36e: Explain the marginal cost of capital’s role in determining the net present value of a project

Answer 5

The WACC is the discount rate that reflects the average risk of the company. When we choose WACC as the discount rate to evaluate a particular project, we assume that:

• The project under consideration is an average risk project
• The project will have constant capital structure throughout tis life

The cost of capital for a paritcular project should reflect the risk inherent in that particular project, which will not necessarily be the same as the risk of the company’s average project.

• If a project has greater risk than the firm’s existing projects, the WACC is adjuted upward
• if the project has less risk than the firm’s existing projects, the WACC is adjusted downward

Question 6

LOS 36 f: Calculate and interpret the cost of debt capital using the yield to maturity approach and the debt-rating approach.

Answer 6

1. Yield to Maturity approach

The bonds YTM is a measure of the return on the bond assuming that it is purchased at the current market price and held till maturity. So find the yield to maturity of the bond, and multiply it by 1 minus the tax rate, to get your after-tax cost of debt

2. Debt-Rating Approach

When a reliable current market price for the company’s debt is not available, the before-tax cost of debt can be estimated using the yield on similarly rated bonds that also have similar terms to maturity as the company’s existing debt

When using this approach adjustments might have to be made to the before-tax cost of debt of the comparable company

Issues in Estimating Cost of Debt

• Fixed rate vs Floating rate debt- The cost of floating rate debt is more difficult to estimate than the cost of fixed rate
• Debt with option-like features- If currently outstanding bonds contain embedded options, an analysts can only use the YTM on these bonds to estimate the cost of debt if she expects similar bonds to be issued going forward
• Nonrated Debt- If a company does not have any debt outstanding or yields on existing debt are not available, an analyst may not be able to use the YTM or the debt-rating approach to estimate the company’s cost of debt
• Leases- if a company uses leases as a source of finance, the cost of these leases should be included in its cost of capital
  *

Question 7

LOS 36g: Calculate and interpret the cost of noncallable, nonconvertible preferred stock

Answer 7

When preferred stock is noncallable and nonconvertible, has no maturity date, and pays dividends at a fixed rate, the value of the preferred stock can be calculated using the perpertuity formula

• Current value of preferred = Preferred dividend per share/ cost of preferred

Rearranging this equation gives us the cost of preferred stock

• cost of preferred = preferred dividend per share/ current value of preferred

Question 8

LOS 36h: Calculate and interpret the cost of equity capital using the capital asset pricing model approach, the dividend discount model approach, and the bond yield plus risk-premium approach.

Answer 8

1. Capital Asset Pricing Model (CAPM)

This model states that the expected rate of return from a stock equals the risk-free interest rate plus a premium for bearing risk

• r_e= R_F + ß_i [E(R_M) - R_F]

where:

• [E(R_M) - R_F] = Equity risk premium
• E(R_M)= Expected return on the market
• ßi= Beta of stock, Beta measures the sensitivity of the stock’s returns to changes in market returns
• R_F= Risk-free rate
• r_e= expected return on stock (cost of equity)

2 Dividend Discount Model Approach

The DDM asserts that the value of a stock equals the present value of its expected future dividends. The Constand Growth or Gordon Growth DDM has dividends grow at a constant rate to determine the cost of equity

• Gordon Growth = P₀= D₁/ (r_e - g)

where:

• P₀= current market value of the security
• D₁= next years dividend
• r_e= required rate of return on common equity
• g= the firms expected constant growth rate of dividends

Rearranging the above equation give us a formula to calculate the required return on equity:

• r_e= (D₁/P₀) + g

The growth rate, g, is a very important variable in this model. There are two ways to determine the growth rate:

1. Use the forecasted growth rate from a published source or vendor
2. Calculate a company’s sustainable growth rate using the following formula:

• g = (1 - (D/EPS)) x ROE, where (1- (D/EPS)) = Earnings retention rate

3 Bond Yield Plus Risk Premium Approach

This approach is based on the assumption that the cost of capital for riskier cash flows is higher than that of less risky cash flows. Therefore we can calculate the return on equity by adding a risk premium to the before-tax cost of debt

• r_e= r_d + risk premium

Question 9

LOS 36i; Compare and interpret the beta and cost of capital for a project

Answer 9

Beta can be calculated by regressing the company’s stock returns against market returns for a given period. The results will be in the following format:

• R_i= a +bR_m

where:

• a = estimate of the intercept
• b= estimated slope of regression (Beta)
• R_i= the company’s stock’s return
• R_m= market returns over a given period

Beta estimates are sensitive to many factors and the following issued should be considered when determing beta:

• Beta estimates are based on historical returns and are therefore sensitive to the length of the estimation period
• Smaller standard errors are found when beta are estimated using small return intervals
• Betas are sensitive to the choice of the market index against which stock returns are regressed
• Betas are believed to revert toward 1 over time, which implies that the risk of an individual project or firm equals market risk over the long run
• Small-cap stocks generally have greater risks and returns compared to large-cap stocks

A company or a project’s beta is exposed to the following systematic (nondiversifiable) risks:

• Business Risk comprises of sales risk and operating risk
• Financial risk refers to the nuncertainty of profits and cash flows because of the use of fixed-cost financing sources such as debt and leases

Analysts use the pure-play method to estimate the beta of a particular project or of a company that is not publicly traded.

• First we find a comparable company that faces similar business risk as the company or project under study and estimate the equity beta of that company
• To remove all elements of financial risk from the comparable’s beta we “unlever” the beta. This unlevered beta reflects only the business risk of comparable and is known as asset beta
• Finally, we adjust the unlevered beta of the comparable for the level of financial risk (leverage) in the project or company under study

Question 10

LOS 36j: Describe uses of country risk premiums in estimating the cost of equity

Answer 10

Beta does not effectively capture country risk in developing nations. To deal with this problem, the CAPM equation for stocks in developing countries is modified to add a country spread to the market risk premium

• r_e= R_F + ß [E(R_M) - R_F + CRP]

The CRP is calculated as the product of sovereign yield spread and the ratio of the volatility of the developing country’s equity market to the volatility of the sovereign bond market. The sovereign yield spread is the difference between the developing country’s government bond yield and the yield of a similar maturity bond issued by the developed country

CPR = Sovereign Yield Spread x Annualized standard deviation of equity index /

annualized standard deviation of sovereign bond market in terms of the developed markets currency

Question 11

LOS 36k: Describe the marginal cost of capital schedule, explain why it may be upward-sloping with repect to additional capital and calculate and interpret its break-points

Answer 11

A company’s MCC increases as additional capital is raised. This is because of the following reasons:

• The company may have existing debt covenants that restrict it from issuing debt with similar senority.
• Due to economies of scale in raising significant amount of a component of capital in one go, firms may deviate from their target capital structure over the short term

The marginal cost of capital schedule shows the WACC at different amounts of total capital. The schedule is upward sloping. The amount of capital at which the WACC changes is referred to as a break point, which is calculated as so:

break point = Amount of capital at which a component’s cost of capital changes /

Proportion of new capital raised from the component

Question 12

LOS 36l: Explain and determine the correct treatment of flotation costs

Answer 12

Flotation costs refer to the fee charged by investment bankers to assist a company in raising new capital. In the case of debt and preferred stock, we do not usually incorporate flotation costs in the estimated cost of capital because the amount of these costs is quite small, often less than 1%. However, for equity issues, flotation costs are usually quit significant

There are 2 ways of accounting for flotation costs

1. Incorporates flotation costs into the cost of capital. When this approach is applied, the cost of capital is calculated in the following manner:
   
   • r_e = [D₁ / P₀ (1 -f)] + g, where f= flotation costs as a % of the issue price
   • This is not the best because flotation costs are a part of the initial cash outlay for a project, and adjusting the cost of capital adjusts the present value of all future cash flows.
2. The 2nd and more correct way to account for flotation costs is to adjust the cash flows used in the valuation. We add the estimated dollar amount of flotation costs to the initial cost of the project