MGT 181 Chapter 14 Notes PDF

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Chapter 14.1 -

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The return an investor in a security receives is essentially the cost of that security to the company issuing it Note: The required return being 10 percent means that the investment has a positive NPV if the return exceeds 10 percent - Another interpretation is that the firm must earn 10 percent on the investment to compensate its investors for the use of capital needed to finance the project (10 percent is the cost of capital for the investment) The cost of capital for a risk-free investment is the risk-free rate, which ends up being used for discounting cash flows of a risk-free project The cost of capital depends primarily on the use of the funds, not the source Note: The debt-equity ratio reflects the firm’s target capital structure A firm’s cost of capital will indeed reflect both the cost of debt capital and the cost of equity capital

Chapter 14.2 -

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Cost of Equity- The return that equity investors require on their investment in the firm There is no way of directly observing the cost of equity, so this must be estimated via approaches such as the dividend growth model approach and the security market line (SML) approach Reminder: P0 = D1/(Re - g) (Constant growth dividend model, Re = required return on stock) - Re = D1/P0 + g (Cost of equity capital, Re) Two ways of estimating the growth rate, g (other quantities for Re are easily obtained) - Use historical growth rates - Use analysts’ forecasts of future growth rates - You can end up using data from multiple sources and then averaging them up to obtain the estimate, which will end up being an arithmetic average The advantage of using the dividend growth model is its simplicity (ease of use/calculation) The disadvantages of using the dividend growth model include that it is applicable to companies that pay dividends (useless in many cases); the assumption is that dividends grow at a constant rate, and also a disadvantage is that the estimated cost of equity is heavily sensitive to the estimated growth rate. Finally, no risk is explicitly considered, unlike for the SML approach SML Approach equation (Re) - Re = Rf + βe(Rm - Rf) To use the SML approach, the risk-free rate, market risk premium estimate, and relevant beta estimate are all needed The advantages of the SML approach are that it adjusts for risk and is applicable to companies other than those with steady dividend growth

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The disadvantages of the SML approach are that the market risk premium and beta estimates may prove harmful for the cost of equity if those estimates are poor, and we rely on the past to predict the future with the SML approach Note: Both discussed approaches are applicable with similar answers, so in that case we can have confidence that our estimates seem valid

Chapter 14.3 -

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Cost of Debt- The return the firm’s creditors demand on new borrowing - We could determine the beta for the firm’s debt and use the SML to estimate the required return on debt in the same manner as for return on equity (not necessary) - The cost of debt simply refers to the interest rate the firm must pay on new borrowing, and we can observe those rates in financial markets - Hence, there is no need for estimating betas for the debt since we can directly observe the rate we need to know Reminder: Preferred stock has a fixed dividend paid every period forever, so a share of preferred stock is a perpetuity - Rp = D/P0 (Cost of preferred stock, Rp) - The cost of preferred stock is equal to the dividend yield on the preferred stock, and this cost can also be estimated by observing required returns for similarly rated shares of preferred stock

Chapter 14.4 -

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We calculate the market value of the firm’s equity by taking the number of shares outstanding and multiplying it by the price per share (E) We calculate the market value of the firm’s debt by multiplying the market price of a single bond by the number of bonds outstanding (D) V = E + D (V is the combined market value of debt and equity) - 100% = E/V + D/V (Capital structure weights) Note: If we are determining the discount rate for after tax cash flows, the discount rate must also be expressed on an after tax basis, and we must be able to distinguish between the pre tax and after tax cost of debt After-tax interest rate is equal to the pre-tax rate multiplied by 1 minus the tax rate - After-tax interest rate = RD*(1-TC) In order to calculate a firm’s overall cost of capital, we multiply the capital structure weights by the associated costs and add them up - Weighted Average Cost of Capital (WACC)- The weighted average of the cost of equity and the after-tax cost of debt - WACC = (E/V)*RE + (D/V)*RD*(1-TC) - The interpretation of WACC is the overall return the firm must earn on its existing assets to maintain the value of its stock; also the required return on any investments by the firm that have the same risks as existing

operations WACC = (E/V)*RE + (P/V)*RP+ (D/V)*RD*(1-TC) (Preferred Stock usage in capital structure, P/V is percentage of firm’s financing coming from preferred stock, RP is cost of preferred stock) Note: The WACC for a firm reflects the risk and the target capital structure of the firm’s existing assets as a whole, so the firm’s WACC is the appropriate discount rate if the proposed investment is a replica of the firm’s activities The best-known approach for performance evaluation as a usage of the WACC is the economic value added (EVA) method, and similar approaches include market value added (MVA) and shareholder value added (SVA) -

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Chapter 14.5 -

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If the risks of investments are significantly different from those of the overall firm, then the WACC will lead to poor decisions While we know that desirable investments plot above the SML, the use of WACC can lead to incorrect acceptances of risky projects and/or incorrect rejections of safe projects In order to come up with appropriate discount rates in circumstances where the WACC leads to problems, we must examine other investments outside the firm that have the same risk class as the one of consideration, and we must use the market-required return on those other investments as the discount rate Pure Play- A company that focuses on a single line of business Pure Play Approach- The use of a WACC that is unique to a particular project, based on companies in similar lines of business The problems that may arise include not being able to find suitable companies, and this results in difficulty for determining the appropriate discount rate Since there are many difficulties for objectively establishing discount rates in the individual projects, firms use an approach involving making subjective adjustments to the WACC - With this subjective approach, the WACC of the firm may change as economic conditions change, and the discount rates will also change as this happens Note: Some risk adjustment is always better than no risk adjustment, even if the risk adjustment is subjective

Chapter 14.6 -

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To calculate cash flow from assets, we need to calculate the firm’s tax bill without debt financing, which is EBIT multiplied by the firm’s tax rate (EBIT*TC) - We also need to calculate cash flow from assets the normal way with adjusted taxes, created an adjusted cash flow from assets (CFA) - CFA = EBIT + Depreciation - EBIT*TC - Change in NWC - Capital Spending = EBIT*(1-TC) + Depreciation - Change in NWC - Capital Spending Note: At this point, we can value the quantity by using the growing perpetuity formula if

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the firm is growing steadily In sum, valuing a firm is the same as valuing a project, except for the fact that we must adjust taxes to remove any effects of debt financing

Chapter 14.7 -

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Flotation Costs- Costs incurred when a firm is required to issue/float new bonds and stock for a new project Note: We can calculate a weighted average flotation cost by multiplying the equity flotation cost by the percentage of equity and the debt flotation cost by the percentage of debt, and then add both quantities together - Fa = (E/V)*Fe + (D/V)*Fd - This formula tells us that for every dollar in outside financing needed for new projects, the firm must raise 1/(1-Fa) Note: In these calculations, it is important that the firms must use the target weights since there is less risk of using the wrong weights, and this will take into account the debt-equity ratio and method of financing a particular project (all debt now and equity later, or vice versa) The implicit assumption with flotation costs is that firms must always raise the capital necessary for new investments, but this is not usually the case in reality - Firms rarely sell equity; rather, the internally generated cash flows are enough to cover equity for capital spending, so the debt portion must be raised externally...