Cost of Capital Instructors ManualHomeLeeds 资本成本教师手册家居利兹.docx

Cost of Capital Instructors ManualHomeLeeds 资本成本教师手册家居利兹.docx

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CostofCapitalInstructorsManualHomeLeeds资本成本教师手册家居利兹

Chapter10（12e）（9-11e）

TheCostofCapital

MINI-CASE

Duringthelastfewyears,HarryDavisIndustrieshasbeentooconstrainedbythehighcostofcapitaltomakemanycapitalinvestments.Recently,though,capitalcostshavebeendeclining,andthecompanyhasdecidedtolookseriouslyatamajorexpansionprogramthathadbeenproposedbythemarketingdepartment.AssumethatyouareanassistanttoLeighJones,thefinancialvice-president.YourfirsttaskistoestimateHarryDavis’costofcapital.Joneshasprovidedyouwiththefollowingdata,whichshebelievesmayberelevanttoyourtask:

1.Thefirm'staxrateis40percent.

2.ThecurrentpriceofHarryDavis’12percentcoupon,semiannualpayment,noncallablebondswith15yearsremainingtomaturityis$1,153.72.HarryDavisdoesnotuseshort-terminterest-bearingdebtonapermanentbasis.Newbondswouldbeprivatelyplacedwithnoflotationcost.

3.Thecurrentpriceofthefirm's10percent,$100parvalue,quarterlydividend,perpetualpreferredstockis$113.10.HarryDaviswouldincurflotationcostsof$2.00pershareonanewissue.

4.HarryDavis’commonstockiscurrentlysellingat$50pershare.Itslastdividend（d0）was$4.19,anddividendsareexpectedtogrowataconstantrateof5percentintheforeseeablefuture.HarryDavis’betais1.2;theyieldont-bondsis7percent;andthemarketriskpremiumisestimatedtobe6percent.Forthebond-yield-plus-risk-premiumapproach,thefirmusesa4percentagepointriskpremium.

5.HarryDavis’targetcapitalstructureis30percentlong-termdebt,10percentpreferredstock,and60percentcommonequity.

Tostructurethetasksomewhat,Joneshasaskedyoutoanswerthefollowingquestions.

a.1.WhatsourcesofcapitalshouldbeincludedwhenyouestimateHarryDavis’weightedaveragecostofcapital（WACC）?

Answer:

TheWACCisusedprimarilyformakinglong-termcapitalinvestmentdecisions,i.e.,forcapitalbudgeting.Thus,theWACCshouldincludethetypesofcapitalusedtopayforlong-termassets,andthisistypicallylong-termdebt,preferredstock（ifused）,andcommonstock.Short-termsourcesofcapitalconsistof

（1）spontaneous,noninterest-bearingliabilitiessuchasaccountspayableandaccrualsand

（2）short-terminterest-bearingdebt,suchasnotespayable.Ifthefirmusesshort-terminterest-bearingdebttoacquirefixedassetsratherthanjusttofinanceworkingcapitalneeds,thentheWACCshouldincludeashort-termdebtcomponent.Noninterest-bearingdebtisgenerallynotincludedinthecostofcapitalestimatebecausethesefundsarenettedoutwhendetermininginvestmentneeds,thatis,netratherthangrossworkingcapitalisincludedincapitalexpenditures.

a.2.Shouldthecomponentcostsbefiguredonabefore-taxoranafter-taxbasis?

Answer:

Stockholdersareconcernedprimarilywiththosecorporatecashflowsthatareavailablefortheiruse,namely,thosecashflowsavailabletopaydividendsorforreinvestment.Sincedividendsarepaidfromandreinvestmentismadewithafter-taxdollars,allcashflowandrateofreturncalculationsshouldbedoneonanafter-taxbasis.

a.3.Shouldthecostsbehistorical（embedded）costsornew（marginal）costs?

Answer:

Infinancialmanagement,thecostofcapitalisusedprimarilytomakedecisionswhichinvolveraisingnewcapital.Thus,therelevantcomponentcostsaretoday'smarginalcostsratherthanhistoricalcosts.

b.WhatisthemarketinterestrateonHarryDavis’debtanditscomponentcostofdebt?

Answer:

HarryDavis’12percentbondwith15yearstomaturityiscurrentlysellingfor$1,153.72.Thus,itsyieldtomaturityis10percent:

01232930

||||||

-1,153.726060606060

1,000

Entern=30,PV=-1153.72,pmt=60,andFV=1000,andthenpresstheibuttontofindrd/2=i=5.0%.Sincethisisasemiannualrate,multiplyby2tofindtheannualrate,rd=10%,thepre-taxcostofdebt.

Sinceinterestistaxdeductible,UncleSam,ineffect,payspartofthecost,andHarryDavis’relevantcomponentcostofdebtistheafter-taxcost:

rd（1-T）=10.0%（1-0.40）=10.0%（0.60）=6.0%.

OptionalQuestion

Shouldflotationcostsbeincludedintheestimate?

Answer:

Theactualcomponentcostofnewdebtwillbesomewhathigherthan6percentbecausethefirmwillincurflotationcostsinsellingthenewissue.However,flotationcostsaretypicallysmallonpublicdebtissues,and,moreimportant,mostdebtisplaceddirectlywithbanks,insurancecompanies,andthelike,andinthiscaseflotationcostsarealmostnonexistent.

OptionalQuestion

Shouldyouusethenominalcostofdebtortheeffectiveannualcost?

Answer:

Our10percentpre-taxestimateisthenominalcostofdebt.Sincethefirm'sdebthassemiannualcoupons,itseffectiveannualrateis10.25percent:

（1.05）2-1.0=1.1025-1.0=0.1025=10.25%.

However,nominalratesaregenerallyused.Thereasonisthatthecostofcapitalisusedincapitalbudgeting,andcapitalbudgetingcashflowsaregenerallyassumedtooccuratyear-end.Therefore,usingnominalratesmakesthetreatmentofthecapitalbudgetingdiscountrateandcashflowsconsistent.

c.1.Whatisthefirm'scostofpreferredstock?

Answer:

Sincethepreferredissueisperpetual,itscostisestimatedasfollows:

rps=

=

=

=0.090=9.0%.

Note

（1）thatflotationcostsforpreferredaresignificant,sotheyareincludedhere,

（2）thatsincepreferreddividendsarenotdeductibletotheissuer,thereisnoneedforataxadjustment,and（3）thatwecouldhaveestimatedtheeffectiveannualcostofthepreferred,butasinthecaseofdebt,thenominalcostisgenerallyused.

c.2.HarryDavis’preferredstockisriskiertoinvestorsthanitsdebt,yetthepreferred'syieldtoinvestorsislowerthantheyieldtomaturityonthedebt.Doesthissuggestthatyouhavemadeamistake?

（Hint:

thinkabouttaxes.）

Answer:

Corporateinvestorsownmostpreferredstock,because70percentofpreferreddividendsreceivedbycorporationsarenontaxable.Therefore,preferredoftenhasalowerbefore-taxyieldthanthebefore-taxyieldondebtissuedbythesamecompany.Note,though,thattheafter-taxyieldtoacorporateinvestor,andtheafter-taxcosttotheissuer,arehigheronpreferredstockthanondebt.

d.1.Whatarethetwoprimarywayscompaniesraisecommonequity?

Answer:

Afirmcanraisecommonequityintwoways:

（1）byretainingearningsand

（2）byissuingnewcommonstock.

d.2.Whyisthereacostassociatedwithreinvestedearnings?

Answer:

Managementmayeitherpayoutearningsintheformofdividendsorelseretainearningsforreinvestmentinthebusiness.Ifpartoftheearningsisretained,anopportunitycostisincurred:

stockholderscouldhavereceivedthoseearningsasdividendsandtheninvestedthatmoneyinstocks,bonds,realestate,andsoon.

d.3.HarryDavisdoesn’tplantoissuenewsharesofcommonstock.UsingtheCAPMapproach,whatisHarryDavis’estimatedcostofequity?

Answer:

rs=0.07+（0.06）1.2=14.2%.

e.1.Whatistheestimatedcostofequityusingthediscountedcashflow（DCF）approach?

Answer:

=

=

=

=13.8%.

e.2.Supposethefirmhashistoricallyearned15percentonequity（ROE）andretained35percentofearnings,andinvestorsexpectthissituationtocontinueinthefuture.Howcouldyouusethisinformationtoestimatethefuturedividendgrowthrate,andwhatgrowthratewouldyouget?

Isthisconsistentwiththe5percentgrowthrategivenearlier?

Answer:

Anothermethodforestimatingthegrowthrateistousetheretentiongrowthmodel:

g=（1-PayoutRatio）ROE

Inthiscaseg=（0.35）0.15=5.25%.Thisisconsistentwiththe5%rategivenearlier.

e.3.CouldtheDCFmethodbeappliedifthegrowthratewasnotconstant?

How?

Answer:

yes,youcouldusetheDCFusingnonconstantgrowth.YouwouldfindthePVofthedividendsduringthenonconstantgrowthperiodandaddthisvaluetothePVoftheseriesofinflowswhengrowthisassumedtobecomeconstant.

f.Whatisthecostofequitybasedonthebond-yield-plus-risk-premiummethod?

Answer:

rs=company’sownbondyield+riskpremium.

FirstfindtheYTMofthebond:

Entern=30,PV=-1153.72,pmt=60,andFV=1000,andthenpresstheibuttontofindr/2=i=5%.Sincethisisasemiannualrate,multiplyby2tofindtheannualrate,r=10%.

Theassumedriskpremiumis4%,thus

rs=0.10+0.04=14%.

g.Whatisyourfinalestimateforthecostofequity,rs?

Answer:

Thefinalestimateforthecostofequitywouldsimplybetheaverageofthevaluesfoundusingtheabovethreemethods.

CAPM14.2%

DCF13.8

BONDYIELD+R.P.14.0

AVERAGE14.0%

h.WhatisHarryDavis’weightedaveragecostofcapital（WACC）?

Answer:

WACC=wdrd（1-T）+wpsrps+wce（rs）

=0.3（0.10）（0.6）+0.1（0.09）+0.6（0.14）

=0.111=11.1%.

i.WhatfactorsinfluenceHarryDavis’compositeWACC?

Answer:

TherearefactorsthatthefirmcannotcontrolandthosethattheycancontrolthatinfluenceWACC.

FactorsTheFirmCannotControl:

}MarketConditions

LevelOfInterestRates

TaxRates

FactorsTheFirmCanControl:

CapitalStructurePolicy

DividendPolicy

InvestmentPolicy

j.ShouldthecompanyusethecompositeWACCasthehurdlerateforeachofitsprojects?

Answer:

No.ThecompositeWACCreflectstheriskofanaverageprojectundertakenbythefirm.Therefore,theWACConlyrepresentsthe“hurdlerate”foratypicalprojectwithaveragerisk.Differentprojectshavedifferentrisks.Theproject’sWACCshouldbeadjustedtoreflecttheproject’srisk.

k.Whatproceduresareusedtodeterminetherisk-adjustedc