We often see managers and students make the following mistakes when estimating the cost of capital. Although we have discussed these errors previously at separate places in the chapter, they are worth repeating here:
1. Never use the coupon rate on a firm's existing debt as the pre-tax cost of debt. The relevant pre-tax cost of debt is the interest rate the firm would pay if it issued debt today.
2. When estimating the market risk premium for the CAPM method, never use the historical average return on stocks in conjunction with the current risk-free rate. The historical average return on common stocks has been about 13 percent, the historical return on long-termTreasurybonds about 5.5 percent, and the difference between them, which is the historical risk premium, is 7.5 percent. The current risk premium is found as the difference between an estimate of the current expected rate of return on common stocks and the current expectedyield on T-bonds. To illustrate, suppose an estimate of the future return on common stock is 10 percent, and the current rate on long-term T-bonds is 4 percent. This implies that you expect to earn 10 percent if you buy stock today and 4 percent if you buy bonds. Therefore, this implies a current market risk premium of 10% — 4% = 6%. A case could be made for using either the historical or the current risk premium, but it would be wrong to take the historical rate of return on the market, 13 percent, subtract from it the current 4 percent rate on T-bonds, and then use 13% — 4% = 9% as the risk premium. Never use the book value of equity when estimating the capital structure weights for the WACC. Your first choice should be to use the target capital structure to determine the weights. If you are an outside analyst and do not know the target weights, it is better to estimate weights based on the current market values of the capital components than on their book values. This is especially true for equity. For example, the stock of an average S&P 500 firm in 2001 had a market value that was about 5.64 times its book value, and in general, stocks' market values are rarely close to their book values. If the company's debt is not publicly traded, then it is reasonable to use the book value of debt to estimate the weights, since book and market values of debt, especially short-term debt, are usually close to one another. To summarize, if you don't know the target weights, then use market values of equity rather than book values to obtain the weights used to calculate WACC. Always remember that capital components are funds that come from investors. If it's not from an investor, then it's not a capital component. Sometimes the argument is made that accounts payable and accruals are sources of funding and should be included in the calculation of the WACC. However, these accounts are due to operating relationships with suppliers and employees, and they are deducted when determining the investment requirement for a project. Therefore, they should not be included in the WACC. Of course, they are not ignored in either corporate valuation or capital budgeting. As we show in Chapter 9, current liabilities do affect cash flow, hence have an effect on corporate valuation. Moreover, in Chapter 8 we show that the same is true for capital budgeting, namely, that current liabilities affect the cash flows of a project, but not its WACC.16
What are four common mistakes people make when estimating the WACC?
This chapter showed how the cost of capital is developed for use in capital budgeting.
• The cost of capital used in capital budgeting is a weighted average of the types of capital the firm uses, typically debt, preferred stock, and common equity.
• The component cost of debt is the after-tax cost of new debt. It is found by multiplying the cost of new debt by (1 — T), where T is the firm's marginal tax rate: rd(1 — T).
16The same reasoning could be applied to other items on the balance sheet, such as deferred taxes. The existence of deferred taxes means that the government has collected less in taxes than a company would owe if the same depreciation and amortization rates were used for taxes as for stockholder reporting. In this sense, the government is "making a loan to the company." However, the deferred tax account is not a source of funds from investors, hence it is not considered to be a capital component. Moreover, the cash flows that are used in capital budgeting and in corporate valuation reflect the actual taxes that the company must pay, not the "normalized" taxes it might report on its income statement. In other words, the correct adjustment for the deferred tax account is made in the cash flows, not in the WACC.
To find the current S&P 500 market to book ratio, go to yahoo.marketguide.com, get the stock quote for any company, and select ratio comparison.
The component cost of preferred stock is calculated as the preferred dividend divided by the net issuing price, where the net issuing price is the price the firm receives after deducting flotation costs: rps = Dps/Pn.
The cost of common equity, rs, is also called the cost of common stock. It is the rate of return required by the firm's stockholders, and it can be estimated by three methods: (1) the CAPM approach, (2) the dividend-yield-plus-growth-rate, or DCF, approach, and (3) the bond-yield-plus-risk-premium approach.
To use the CAPM approach, one (1) estimates the firm's beta, (2) multiplies this beta by the market risk premium to determine the firm's risk premium, and (3) adds the firm's risk premium to the risk-free rate to obtain the cost of common stock: rs = rRF + (RPm)W
The best proxy for the risk-free rate is the yield on long-term T-bonds. To use the dividend-yield-plus-growth-rate approach, which is also called the discounted cash flow (DCF) approach, one adds the firm's expected growth rate to its expected dividend yield: rs = D1/P0 + g.
The growth rate can be estimated from historical earnings and dividends or by use of the retention growth model, g = (1 — Payout)(Return on equity), or it can be based on analysts' forecasts.
The bond-yield-plus-risk-premium approach calls for adding a risk premium of from 3 to 5 percentage points to the firm's interest rate on long-term debt: rs = Bond yield + RP.
Each firm has a target capital structure, defined as that mix of debt, preferred stock, and common equity that minimizes its weighted average cost of capital (WACC):
Various factors affect a firm's cost of capital. Some of these factors are determined by the financial environment, but the firm influences others through its financing, investment, and dividend policies.
Ideally, the cost of capital for each project should reflect the risk of the project itself, not the risks associated with the firm's average project as reflected in its composite WACC.
Failing to adjust for differences in project risk would lead a firm to accept too many value-destroying risky projects and reject too many value-adding safe ones. Over time, the firm would become more risky, its WACC would increase, and its shareholder value would decline.
A project's stand-alone risk is the risk the project would have if it were the firm's only asset and if stockholders held only that one stock. Stand-alone risk is measured by the variability of the asset's expected returns.
Corporate, or within-firm, risk reflects the effects of a project on the firm's risk, and it is measured by the project's effect on the firm's earnings variability. Market, or beta, risk reflects the effects of a project on the riskiness of stockholders, assuming they hold diversified portfolios. Market risk is measured by the project's effect on the firm's beta coefficient.
Most decision makers consider all three risk measures in a judgmental manner and then classify projects into subjective risk categories. Using the composite WACC as a starting point, risk-adjusted costs of capital are developed for each category. The risk-adjusted cost of capital is the cost of capital appropriate for a given project, given the riskiness of that project. The greater the risk, the higher the cost of capital. Firms may be able to use the CAPM to estimate the cost of capital for specific projects or divisions. However, estimating betas for projects is difficult. The pure play and accounting beta methods can sometimes be used to estimate betas for large projects or for divisions.
• Companies generally hire an investment banker to assist them when they issue common stock, preferred stock, or bonds. In return for a fee, the investment banker helps the company with the terms, price, and sale of the issue. The banker's fees are often referred to as flotation costs. The total cost of capital should include not only the required return paid to investors but also the flotation fees paid to the investment banker for marketing the issue.
• When calculating the cost of new common stock, the DCF approach can be adapted to account for flotation costs. For a constant growth stock, this cost can be expressed as: re = D1/[P0(1 — F)] + g. Note that flotation costs cause re to be greater than rs.
• Flotation cost adjustments can also be made for debt. The bond's issue price is reduced for flotation expenses and then used to solve for the after-tax yield to maturity.
• The three equity cost estimating techniques discussed in this chapter have serious limitations when applied to small firms, thus increasing the need for the small-business manager to use judgment.
The cost of capital as developed in this chapter is used in the following chapters to determine the value of a corporation and to evaluate capital budgeting projects. In addition, we will extend the concepts developed here in Chapter 13, where we consider the effect of the capital structure on the cost of capital.
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