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Chapter Introduction

Creating Value at Disney

Walt Disney Co. (DIS) is one of the world?s most successful companies. Despite a tough economic environment over the past few years, Disney?s managers have worked hard to create value for shareholders by investing in assets that earn more than the cost of the capital used to acquire them. For example, if a project earns 20%, but the capital invested in it costs only 10%, taking on the project will increase the firm?s value and thus its stock price.

Capital is obtained in three primary forms: debt, preferred stock, and common equity, with equity acquired by retaining earnings and issuing new stock. The investors who provide capital to Disney expect to earn at least their required rate of return on that capital, and the required return represents the firm?s cost of capital. ?A variety of factors influence the cost of capital. Some?including interest rates, state and federal tax policies, and general economic conditions?are outside the firm?s control. However, the firm?s decisions regarding how it raises capital and how it invests those funds also have a profound effect on its cost of capital.

Estimating the cost of capital for a company such as Disney is conceptually straightforward. Disney?s capital comes from debt plus common equity, so its cost of capital depends largely on the level of interest rates in the economy and the marginal stockholder?s required rate of return on equity. However, Disney operates many different divisions throughout the?world, so the corporation is similar to a portfolio that contains a number of different stocks, each with a different risk. Recall that portfolio risk is a weighted average of the relevant risks of the different stocks in the portfolio.

Similarly, each of Disney?s divisions has its own level of risk and hence its own cost of capital. Therefore, Disney?s overall cost of capital is a weighted average of its divisions? costs. For example, Disney?s Media Networks?s segment (which includes ABC and ESPN) probably has a different cost of capital than its Parks and Resorts unit (which includes Disney World Resort, Disneyland, and the Disney Cruise Line, and Disney Vacation Club); and even projects within divisions have different costs because some projects are riskier than others. Moreover, its overseas projects may have different risks and thus different costs of capital than similar domestic projects. As we will see in this chapter, the cost of capital is an essential element in a firm?s capital budgeting process. This process is the primary determinant of the firm?s long-run stock price.

Putting Things in Perspective

In the last four chapters, we explained how risk influences prices and required rates of return on bonds and stocks. A firm?s primary objective is to maximize its shareholders? value. The principal way value is increased is by investing in projects that earn more than their cost of capital. In the next two chapters, we will see that a project?s future cash flows can be forecasted and that those cash flows can be discounted to find their present value. Then if the PV of the future cash flows exceeds the project?s cost, the firm?s value will increase if the project is accepted. However, we need a discount rate to find the PV of these future cash flows, and that discount rate is the firm?s cost of capital. Finding the cost of the capital required to take on new projects is the primary focus of this chapter.

Most formulas used in this chapter were developed earlier, when we examined the required rates of return on bonds and stocks in?Chapters 7?and?9.?Indeed, the rates of return that investors require on bonds and stocks represent the costs of those securities to the firm.?As we shall see, companies estimate the required returns on their securities, calculate a weighted average of the costs of their different types of capital, and use this average cost for capital budgeting purposes.

When you finish this chapter, you should be able to:

? Explain why the weighted average cost of capital (WACC) is used in capital budgeting.

? Estimate the costs of different capital components?debt, preferred stock, retained earnings, and common stock.

? Combine the different component costs to determine the firm?s WACC.

These concepts are necessary to understand the firm?s capital budgeting process.

An Overview of the Weighted Average Cost of Capital (WACC)

Table 10.1?shows Allied Food Products?s balance sheet as presented in?Chapter 3, with three additions: (1) the actual capital supplied by investors (banks, bondholders, and stockholders), calculated using the accounting-based book values; (2) the market values of the investor-supplied capital; and (3) the target capital structure that Allied plans to use in the future.

Table?10.1Allied Food Products: Capital Structure Used to Calculate the WACC (Dollars in Millions)

Notes:

? The market value calculations assume that the company?s debt is trading at par, so the market value of debt equals the book value of debt.

? The market value of equity is the share price of common stock multiplied by the number of shares outstanding. At 12/31/16, the firm has 50 million shares outstanding, and its stock sold for $23.06 per share.

When calculating the WACC, our concern is with capital that must be provided byinvestors?interest-bearing debt, preferred stock, and common equity. Accounts payable and accruals, which arise spontaneously when capital budgeting projects are undertaken, are not included as part of investor-supplied capital because they do not come directly from investors. Looking at column 1 of?Table 10.1, we see that using the accounting-based book values, Allied?s capital consists of 47.8% debt and 52.2% equity.

Although these accounting-based measures are important, Allied?s investors are more concerned about the current market value of the company?s debt and equity, which are shown in column 2 of?Table 10.1. To keep things relatively simple, we assume that the market value of Allied?s debt is equal to its book value (i.e., we assume that its average outstanding debt is trading at its par value). ?The market?value of equity is the number of shares of stock outstanding multiplied by the current stock price. Recall fromChapter 3?that Allied has 50 million shares of common stock outstanding, and the company?s stock currently trades at $23.06 per share, which means that the market value of its equity is $1.153 billion. Because the market value of its equity exceeds the book value of its equity, we see that Allied?s market-based capital structure has a higher percentage of equity (57.3%) than the capital structure that was calculated using its accounting-based book values (52.2%).

Although these market-based numbers are a useful starting point, what ultimately matters is the?target capital structure, which refers to how Allied plans to raise capital to fund its future projects. In?Chapter 13, we explore in more detail how companies determine their target capital structure. As we will see, there is an optimal capital structure?one where the percentages of debt, preferred stock, and common equity maximize the firm?s value. As shown in column 3 of?Table 10.1, Allied Food has concluded that its target capital structure should include 45% debt, 2% preferred stock, and 53% common equity; and in the future it plans to raise capital in those proportions. Therefore, we use those target weights when we calculate Allied?s weighted average cost of capital. It follows that Allied?s overall cost of capital is a weighted average of the costs of the various types of capital it uses, where the weights correspond to the company?s target capital structure.

0-2Basic Definitions

The investor-supplied items?debt, preferred stock, and common equity?are calledcapital components. Increases in assets must be financed by increases in these capital components. The cost of each component is called its?component cost;?for example, Allied can borrow money at 10%, so its component cost of debt is 10%. ?These costs are then combined to form a weighted average cost of capital, which is used in the firm?s capital budgeting analysis. Throughout this chapter, we concentrate on the three major capital components. The following symbols identify the cost and weight of each:

? . It can be found in several ways, including calculating the yield to maturity on the firm?s currently outstanding bonds.

? , where T is the firm?s marginal tax rate.?is the debt cost used to calculate the weighted average cost of capital.?As we shall see, the after-tax cost of debt is lower than its before-tax cost because interest is tax deductible.

? , found as the yield investors expect to earn on the preferred stock. Preferred dividends are not tax deductible; hence, the before- and after-tax costs of preferred are equal.

? , or?internal equity.?It is the?developed in?? Chapters 8?and?? 9?and defined there as the rate of return that investors require on a firm?s common stock. Most firms, once they have become well established, obtain all of their new equity as retained earnings; hence,??is their cost of all new equity.

? , or common equity raised by issuing new stock. As we will see,??is equal to??plus a factor that reflects the cost of issuing new stock. Note, though, that established firms such as Allied Food rarely issue new stock; hence,??is rarely a relevant consideration except for very young, rapidly growing firms.

? ,?,?, preferred stock, and common equity (which includes retained earnings, internal equity, and new common stock, external equity). The weights are the percentages of the different types of capital the firm plans to use when it raises capital in the future. Target weights may differ from actual current weights.

? , or overall, cost of capital.

The target proportions of debt?, preferred stock?, and common equity?, along with the costs of those components, are used to calculate the firm?s?weighted average cost of capital, WACC. We assume at this point that all new common equity is raised as retained earnings, as is true for most companies; hence, the cost of common equity is?:

10.1

Note that only debt has a tax adjustment factor, (1 ? T). As discussed in the next section, this is because interest on debt is tax deductible, but preferred dividends and the returns on common stock (dividends and capital gains) are not.

These definitions and concepts are discussed in the remainder of the chapter, using Allied Food for illustrative purposes. Later in?Chapter 13, we extend the discussion to show how the optimal mix of securities minimizes the firm?s cost of capital and maximizes its value.

Cost of Debt,?

The interest rate a firm must pay on its?new?debt is defined as its?before-tax cost of debt,?. Firms can estimate??by asking their bankers what it will cost to borrow or by finding the yield to maturity on their currently outstanding debt (as we illustrated inChapter 7).?However, the?after-tax cost of debt,?,?should be used to calculate the weighted average cost of capital.?This is the interest rate on new debt,?, less the tax savings that result because interest is tax deductible:

10.2

In effect, the government pays part of the cost of debt because interest is tax deductible. Therefore, if Allied can borrow at an interest rate of 10%, and its marginal federal-plus-state tax rate is 40%, its after-tax cost of debt will be 6%:

We use the after-tax cost of debt in calculating the WACC because we are interested in maximizing the value of the firm?s stock, and the stock price depends on?after-tax?cash flows. Because we are concerned with after-tax cash flows and because cash flows and rates of return should be calculated on a comparable basis, we adjust the interest rate downward due to debt?s preferential tax treatment.

It is important to emphasize that the cost of debt is the interest rate on?new?debt, not outstanding debt. We are interested in the cost of new debt because our primaryconcern with the cost of capital is its use in capital budgeting decisions. For example, would a new machine earn a return greater than the cost of the capital needed to acquire the machine? The rate at which the firm has borrowed in the past is irrelevant when answering this question because we need to know the cost of?new capital. For these reasons, the yield to maturity on outstanding debt (which reflects current market conditions) is a better measure of the cost of debt than the coupon rate.?Note that if the yield curve is upward or downward sloping, the cost of long- and short-term debt will differ. In these cases, the yield to maturity on the company?s long-term debt is generally used to calculate the cost of debt because, more often than not, the capital is being raised to fund long-term projects. ?However, as we see in?Chapter 15, some companies regularly use a mix of short-term and long-term debt to finance their projects. When calculating their costs of debt, these companies may choose to calculate an average of their debt costs based on the proportion of long- and short-term debt that they plan to use.

10-4Cost of Preferred Stock,?

The component?cost of preferred stock,?, used to calculate the weighted average cost of capital is the preferred dividend,?, divided by the current price of the preferred stock,?:

10.3

Allied does not have any preferred stock outstanding, but the company plans to issue some in the future and therefore has included it in its target capital structure. Allied would sell this stock to a few large hedge funds, the stock would have a $10.00 dividend per share, and it would be priced at $97.50 a share. Therefore, Allied?s cost of preferred stock would be 10.3%:

As we can see from?Equation 10.3, calculating the cost of preferred stock is easy. This is particularly true for traditional ?plain vanilla? preferred that pays a fixed dividend in perpetuity. However, in?Chapter 9, we noted that some preferred issues have a specified maturity date and we described how to calculate the expected return on these issues. Also, preferred stock may include an option to convert to common stock, which adds another layer of complexity. We leave these more complicated situations for advanced classes. Finally, note that no tax adjustments are made when calculating??because preferred dividends, unlike interest on debt, are?not?tax deductible, so no tax savings are associated with preferred stock.

10-5The Cost of Retained Earnings,?

The costs of debt and preferred stock are based on the returns that investors require on these securities. Similarly, the cost of common equity is based on the rate of return that investors require on the company?s common stock. Note, though, that new common equity is raised in two ways: (1) by retaining some of the current year?s earnings and (2) by issuing new common stock. ?We use the symbol??to designate the?cost of retained earnings?and??to designate the?cost of new common stock, or external equity. Equity raised by issuing stock has a higher cost than equity from retained earnings due to the flotation costs required to sell new common stock. Therefore, once firms get beyond the start-up stage, they normally obtain all of their new equity by retaining earnings.

Some have argued that retained earnings should be ?free? because they represent money that is ?left over? after dividends are paid. Although it is true that no direct costs are associated with retained earnings, this capital still has a cost, an?opportunity cost.The firm?s after-tax earnings belong to its stockholders. Bondholders are compensated by interest payments; preferred stockholders, by preferred dividends. But the net earnings remaining after paying interest and preferred dividends belong to the common stockholders, and these earnings serve to compensate them for the use of their capital. The managers, who work for the stockholders, can either pay out earnings in the form of dividends or retain earnings for reinvestment in the business. When managers make this decision, they should recognize that there is an opportunity cost involved?stockholders could have received the earnings as?dividends and invested this money in other stocks, in bonds, in real estate, or in anything else.?Therefore, the firm needs to earn at least as much on any earnings retained as the stockholders could earn on alternative investments of comparable risk.

What rate of return can stockholders expect to earn on equivalent-risk investments? First, recall from?Chapter 9?that stocks are normally in equilibrium, with expected and required rates of return equal:?. Thus, Allied?s stockholders expect to be able to earn??on their money.?Therefore, if the firm cannot invest retained earnings to earn at least?, it should pay those funds to its stockholders and let them invest directly in stocks or other assets that will provide that return.

Whereas debt and preferred stocks are contractual obligations whose costs are clearly stated within the contracts, stocks have no comparable stated cost rate. That makes it difficult to measure?. However, we can employ the techniques developed in?Chapters 8and?9?to produce reasonably good estimates of the cost of equity from retained earnings. To begin, recall that if a stock is in equilibrium, its?required rate of return,?, must be equal to its?expected rate of return,?. Further, its?required return?is equal to a risk-free rate,?, plus a risk premium, RP, whereas the?expected return?on the stock is its expected dividend yield,?, plus its expected growth rate, g. Thus, we can write the following equation and estimate??using the left term, the right term, or both terms:

10.4

The left term is based on the capital asset pricing model (CAPM) as discussed in?Chapter 8, and the right term is based on the discounted dividend model as developed in?Chapter 9. We discuss these two procedures, in addition to one based on the firm?s own cost of debt, in the following sections.

10-5AThe CAPM Approach

The most widely used method for estimating the cost of common equity is the capital asset pricing model (CAPM) as developed in?Chapter 8. ?Here are the steps used to find:

? Step?1

Estimate the risk-free rate,?. We generally use the 10-year Treasury bond rate as the measure of the risk-free rate, but some analysts use the short-term Treasury bill rate.

? Step?2

Estimate the stock?s beta coefficient,?, and use it as an index of the stock?s risk. The?i?signifies the?ith company?s beta.

? Step?3

Estimate the market risk premium. Recall that the market risk premium is the difference between the return that investors require on an average stock and the risk-free rate.

? Step?4

Substitute the preceding values in the CAPM equation to estimate the required rate of return on the stock in question:

10.5

Thus, the CAPM estimate of??is equal to the risk-free rate,?, plus a risk premium that is equal to the risk premium on an average stock,?, scaled up or down to reflect the particular stock?s risk as measured by its beta coefficient,?.

Assume that in today?s market,?, the market risk premium is?, and Allied?s beta is 1.48. Using the CAPM approach, Allied?s cost of equity is estimated to be 13.0%:

Although the CAPM appears to produce an accurate, precise estimate of?, several potential problems exist. First, as we saw in?Chapter 8, if a firm?s stockholders are not well diversified, they may be concerned with?stand-alone risk?rather than just market risk. In that case, the firm?s true investment risk would not be measured by its beta and the CAPM estimate would understate the correct value of?. Further, even if the CAPM theory is valid, it is hard to obtain accurate estimates of the required inputs because (1) there is controversy about whether to use long-term or short-term Treasury yields for?. (2) It is hard to estimate the beta that investors expect the company to have in the future. (3) It is difficult to estimate the proper market risk premium. As we indicated earlier, the CAPM approach is used most often; but because of the just-noted problems, analysts also estimate the cost of equity using the other approaches discussed in the following sections.

10-5BBond-Yield-Plus-Risk-Premium Approach

In situations where reliable inputs for the CAPM approach are not available, as would be true for a closely held company, analysts often use a somewhat subjective procedure to estimate the cost of equity. Empirical studies suggest that the risk premium on a firm?s stock over its own bonds generally ranges from 3 to 5 percentage points. ?Based on this evidence, one might simply add a judgmental risk premium of 3% to 5% to the interest rate on the firm?s own long-term debt to estimate its cost of equity. Firms with risky, low-rated, and consequently high-interest-rate debt also have risky, high-cost equity; and the procedure of basing the cost of equity on the firm?s own readily observable debt cost utilizes this logic. For example, given that Allied?s bonds yield 10%, its cost of equity might be estimated as follows:

The bonds of a riskier company might have a higher yield, 12%, in which case the estimated cost of equity would be 16%:

Because the 4% risk premium is an estimate based on judgment, the estimated value of??is also judgmental. Therefore, one might use a range of 3% to 5% for the risk premium and obtain a range of 13% to 15% for Allied. Although this method does not produce a precise cost of equity, it should ?get us in the right ballpark.?

10-5CDividend-Yield-Plus-Growth-Rate, or Discounted Cash Flow (DCF), Approach

In?Chapter 9, we saw that both the price and the expected rate of return on a share of common stock depend, ultimately, on the stock?s expected cash flows. For companies that are expected to remain in business indefinitely, the cash flows are the dividends; on the other hand, if investors expect the firm to be acquired by some other company or to be liquidated, the cash flows will be dividends for some number of years plus a price at the horizon date when the firm is expected to be acquired or liquidated. Like most firms, Allied is expected to continue indefinitely, in which case the following equation applies:

10.6

Here??is the current stock price,??is the dividend expected to be paid at the end of Year t, and??is the required rate of return. If dividends are expected to grow at a constant rate, as we saw in?Chapter 9,?Equation 10.6?reduces to this important formula:

10.7

We can solve for??to obtain the required rate of return on common equity, which for the marginal investor is also equal to the expected rate of return:

10.8

Thus, investors expect to receive a dividend yield,?, plus a capital gain, g, for a total expected return of?; and in equilibrium, this expected return is also equal to the required return,?. This method of estimating the cost of equity is called the?discounted cash flow, or?DCF,?method. Henceforth, we will assume that equilibrium exists, which permits us to use the terms??and??interchangeably.

It is easy to calculate the dividend yield; but because stock prices fluctuate, the yield varies from day to day, which leads to fluctuations in the DCF cost of equity. Also, it is difficult to determine the proper growth rate. If past growth rates in earnings and dividends have been relatively stable, and if investors expect a continuation of past trends, g may be based on the firm?s historic growth rate.?However, if the company?s past growth has been abnormally high or low due to a unique situation or because of general economic fluctuations, investors will not project historical growth rates into the future.?In this case, which applies to Allied, g must be obtained in some other manner.

Security analysts regularly forecast growth rates for earnings and dividends, looking at such factors as projected sales, profit margins, and competition. For example,?Value Line Investment Survey, which is available in most libraries, provides?growth rate forecasts for 1,700 companies; Citigroup, UBS, Credit Suisse, Morgan Stanley, and other organizations make similar forecasts. Averages of these forecasts are available on Yahoo! Finance and other websites. Therefore, someone estimating a firm?s cost of equity can obtain analysts? forecasts and use them as a proxy for the growth expectations of investors in general. Then he or she can combine this g with the current dividend yield to estimate?:

Again, note that this estimate of??is based on the assumption that g is expected to remain constant in the future. Otherwise, we must use an average of expected future rates.

To illustrate the DCF approach, Allied?s stock sells for $23.06; its next expected dividend is $1.25; and analysts expect its growth rate to be 8.3%. Thus, Allied?s expected and required rates of return (hence, its cost of retained earnings) are estimated to be 13.7%:

Based on the DCF method, 13.7% is the minimum rate of return that should be earned on retained earnings to justify plowing earnings back into the business rather than paying them out to shareholders as dividends. Put another way, because investors are thought to have an?opportunity?to earn 13.7% if earnings are paid out as dividends, theopportunity cost?of equity from retained earnings is 13.7%.

10-5DAveraging the Alternative Estimates

In our examples, Allied?s estimated cost of equity was 13.0% by the CAPM, 14.0% by the bond-yield-plus-risk premium method, and 13.7% by the DCF method. Which method should the firm use? If management has confidence in one method, it would probably use that method?s estimate alone. Otherwise, it might use some weighted average of the three methods.

As consultants, we have estimated companies? costs of capital on numerous occasions. We generally take into account all three methods, but we rely most heavily on the method that seems best under the circumstances. Judgment is important and comes into play here, as is true for most decisions in finance. Also, we recognize that our final estimate will almost certainly be incorrect to some extent. ?Therefore, we always provide a range and state that in our judgment, the cost of equity is within that range. For Allied, we used a range of 13% to 14%;?the company then used 13.5% as the estimate of its cost of retained earnings when it calculated its WACC:

Final estimate of??used to calculate Allied?s WACC: 13.5%

Cost of New Common Stock,?

Companies generally use an investment banker when they issue new common stock and sometimes when they issue preferred stock or bonds. In return for a fee, investment bankers help the company structure the terms, set a price for the issue, and sell the issue to investors. The bankers? fees are called?flotation costs, and the total cost of the capital raised is the investors? required return plus the flotation cost.

For most firms at most times, equity flotation costs are not an issue because most equity comes from retained earnings. Therefore, in our discussion to this point, we have ignored flotation costs. However, flotation costs can often be substantial. So if a firm does plan to issue new stock, these costs should not be ignored. When firms use investment bankers to raise capital, two approaches can be used to account for flotation costs. ?We describe them in the next two sections.

Add Flotation Costs to a Project?s Cost

In the next chapter, we show that capital budgeting projects typically involve an initial cash outlay followed by a series of cash inflows. One approach to handling flotation costs, found as the sum of the flotation costs for the debt, preferred, and common stock used to finance the project, is to add this sum to the initial investment cost. Because the investment cost is increased, the project?s expected rate of return is reduced. For example, consider a 1-year project with an initial cost (not including flotation costs) of $100 million. After 1 year, the project is expected to produce an inflow of $115 million. Therefore, its expected rate of return is?. However, if the project requires the company to?raise $100 million of new capital and incur $2 million of flotation costs, the total upfront cost will rise to $102 million, which will lower the expected rate of return to?.

10-6BIncrease the Cost of Capital

The second approach involves adjusting the cost of capital rather than increasing the project?s investment cost. If the firm plans to continue using the capital in the future, as is generally true for equity, this second approach theoretically will be better. The adjustment process is based on the following logic. If there are flotation costs, the issuing firm receives only a portion of the capital provided by investors, with the remainder going to the underwriter. To provide investors with their required rate of return on the capital they contributed, each dollar the firm actually receives must ?work harder?; that is, each dollar must earn a higher rate of return than the investors? required rate of return. For example, suppose investors require a 13.7% return on their investment, but flotation costs represent 10% of the funds raised. Therefore, the firm actually keeps and invests only 90% of the amount that investors supplied. In that case, the firm must earn about 14.3% on the available funds in order to provide investors with a 13.7% return on their investment. This higher rate of return is the flotation-adjusted cost of equity.

The DCF approach can be used to estimate the effects of flotation costs. Here is the equation for the?cost of new common stock,?:

10.9

Here?F?is the percentage?flotation cost?required to sell the new stock, so??is the net price per share received by the company.

Assuming that Allied has a flotation cost of 10%, its cost of new common equity,?, would be calculated as follows:

This is 0.6% higher than the previously estimated 13.7% DCF cost of equity, so theflotation cost adjustment?is 0.6%:

The 0.6% flotation cost adjustment can be added to the previously estimated?(Allied management?s estimate of its cost of equity considering all three approaches), resulting in a cost of equity from new common stock, or external equity, of 14.1%:

If Allied earns 14.1% on funds obtained from selling new stock, the investors who purchased that stock will end up earning 13.5%, their required rate of return, on the money they invested. If Allied earns more than 14.1%, its stock price should rise; but the price should fall if Allied earns less than 14.1%.

When Must External Equity Be Used?

Because of flotation costs, dollars raised by selling new stock must ?work harder? than dollars raised by retaining earnings. Moreover, because no flotation costs are involved, retained earnings cost less than new stock. Therefore, firms should utilize retained earnings to the greatest extent possible. However, if a firm has more good investment opportunities than can be financed with retained earnings plus the debt and preferred stock supported by those retained earnings, it may need to issue new common stock. The total amount of capital that can be raised before new stock must be issued is defined as the?retained earnings breakpoint, and it can be calculated as follows:

10.10

Allied?s addition to retained earnings in 2017 is expected to be $66 million (as we will see la

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Chapter Introduction

Creating Value at Disney

Walt Disney Co. (DIS) is one of the world?s most successful companies. Despite a tough economic environment over the past few years, Disney?s managers have worked hard to create value for shareholders by investing in assets that earn more than the cost of the capital used to acquire them. For example, if a project earns 20%, but the capital invested in it costs only 10%, taking on the project will increase the firm?s value and thus its stock price.

Capital is obtained in three primary forms: debt, preferred stock, and common equity, with equity acquired by retaining earnings and issuing new stock. The investors who provide capital to Disney expect to earn at least their required rate of return on that capital, and the required return represents the firm?s cost of capital. ?A variety of factors influence the cost of capital. Some?including interest rates, state and federal tax policies, and general economic conditions?are outside the firm?s control. However, the firm?s decisions regarding how it raises capital and how it invests those funds also have a profound effect on its cost of capital.

Estimating the cost of capital for a company such as Disney is conceptually straightforward. Disney?s capital comes from debt plus common equity, so its cost of capital depends largely on the level of interest rates in the economy and the marginal stockholder?s required rate of return on equity. However, Disney operates many different divisions throughout the?world, so the corporation is similar to a portfolio that contains a number of different stocks, each with a different risk. Recall that portfolio risk is a weighted average of the relevant risks of the different stocks in the portfolio.

Similarly, each of Disney?s divisions has its own level of risk and hence its own cost of capital. Therefore, Disney?s overall cost of capital is a weighted average of its divisions? costs. For example, Disney?s Media Networks?s segment (which includes ABC and ESPN) probably has a different cost of capital than its Parks and Resorts unit (which includes Disney World Resort, Disneyland, and the Disney Cruise Line, and Disney Vacation Club); and even projects within divisions have different costs because some projects are riskier than others. Moreover, its overseas projects may have different risks and thus different costs of capital than similar domestic projects. As we will see in this chapter, the cost of capital is an essential element in a firm?s capital budgeting process. This process is the primary determinant of the firm?s long-run stock price.

Putting Things in Perspective

In the last four chapters, we explained how risk influences prices and required rates of return on bonds and stocks. A firm?s primary objective is to maximize its shareholders? value. The principal way value is increased is by investing in projects that earn more than their cost of capital. In the next two chapters, we will see that a project?s future cash flows can be forecasted and that those cash flows can be discounted to find their present value. Then if the PV of the future cash flows exceeds the project?s cost, the firm?s value will increase if the project is accepted. However, we need a discount rate to find the PV of these future cash flows, and that discount rate is the firm?s cost of capital. Finding the cost of the capital required to take on new projects is the primary focus of this chapter.

Most formulas used in this chapter were developed earlier, when we examined the required rates of return on bonds and stocks in?Chapters 7?and?9.?Indeed, the rates of return that investors require on bonds and stocks represent the costs of those securities to the firm.?As we shall see, companies estimate the required returns on their securities, calculate a weighted average of the costs of their different types of capital, and use this average cost for capital budgeting purposes.

When you finish this chapter, you should be able to:

? Explain why the weighted average cost of capital (WACC) is used in capital budgeting.

? Estimate the costs of different capital components?debt, preferred stock, retained earnings, and common stock.

? Combine the different component costs to determine the firm?s WACC.

These concepts are necessary to understand the firm?s capital budgeting process.

An Overview of the Weighted Average Cost of Capital (WACC)

Table 10.1?shows Allied Food Products?s balance sheet as presented in?Chapter 3, with three additions: (1) the actual capital supplied by investors (banks, bondholders, and stockholders), calculated using the accounting-based book values; (2) the market values of the investor-supplied capital; and (3) the target capital structure that Allied plans to use in the future.

Table?10.1Allied Food Products: Capital Structure Used to Calculate the WACC (Dollars in Millions)

Notes:

? The market value calculations assume that the company?s debt is trading at par, so the market value of debt equals the book value of debt.

? The market value of equity is the share price of common stock multiplied by the number of shares outstanding. At 12/31/16, the firm has 50 million shares outstanding, and its stock sold for $23.06 per share.

When calculating the WACC, our concern is with capital that must be provided byinvestors?interest-bearing debt, preferred stock, and common equity. Accounts payable and accruals, which arise spontaneously when capital budgeting projects are undertaken, are not included as part of investor-supplied capital because they do not come directly from investors. Looking at column 1 of?Table 10.1, we see that using the accounting-based book values, Allied?s capital consists of 47.8% debt and 52.2% equity.

Although these accounting-based measures are important, Allied?s investors are more concerned about the current market value of the company?s debt and equity, which are shown in column 2 of?Table 10.1. To keep things relatively simple, we assume that the market value of Allied?s debt is equal to its book value (i.e., we assume that its average outstanding debt is trading at its par value). ?The market?value of equity is the number of shares of stock outstanding multiplied by the current stock price. Recall fromChapter 3?that Allied has 50 million shares of common stock outstanding, and the company?s stock currently trades at $23.06 per share, which means that the market value of its equity is $1.153 billion. Because the market value of its equity exceeds the book value of its equity, we see that Allied?s market-based capital structure has a higher percentage of equity (57.3%) than the capital structure that was calculated using its accounting-based book values (52.2%).

Although these market-based numbers are a useful starting point, what ultimately matters is the?target capital structure, which refers to how Allied plans to raise capital to fund its future projects. In?Chapter 13, we explore in more detail how companies determine their target capital structure. As we will see, there is an optimal capital structure?one where the percentages of debt, preferred stock, and common equity maximize the firm?s value. As shown in column 3 of?Table 10.1, Allied Food has concluded that its target capital structure should include 45% debt, 2% preferred stock, and 53% common equity; and in the future it plans to raise capital in those proportions. Therefore, we use those target weights when we calculate Allied?s weighted average cost of capital. It follows that Allied?s overall cost of capital is a weighted average of the costs of the various types of capital it uses, where the weights correspond to the company?s target capital structure.

0-2Basic Definitions

The investor-supplied items?debt, preferred stock, and common equity?are calledcapital components. Increases in assets must be financed by increases in these capital components. The cost of each component is called its?component cost;?for example, Allied can borrow money at 10%, so its component cost of debt is 10%. ?These costs are then combined to form a weighted average cost of capital, which is used in the firm?s capital budgeting analysis. Throughout this chapter, we concentrate on the three major capital components. The following symbols identify the cost and weight of each:

? . It can be found in several ways, including calculating the yield to maturity on the firm?s currently outstanding bonds.

? , where T is the firm?s marginal tax rate.?is the debt cost used to calculate the weighted average cost of capital.?As we shall see, the after-tax cost of debt is lower than its before-tax cost because interest is tax deductible.

? , found as the yield investors expect to earn on the preferred stock. Preferred dividends are not tax deductible; hence, the before- and after-tax costs of preferred are equal.

? , or?internal equity.?It is the?developed in?? Chapters 8?and?? 9?and defined there as the rate of return that investors require on a firm?s common stock. Most firms, once they have become well established, obtain all of their new equity as retained earnings; hence,??is their cost of all new equity.

? , or common equity raised by issuing new stock. As we will see,??is equal to??plus a factor that reflects the cost of issuing new stock. Note, though, that established firms such as Allied Food rarely issue new stock; hence,??is rarely a relevant consideration except for very young, rapidly growing firms.

? ,?,?, preferred stock, and common equity (which includes retained earnings, internal equity, and new common stock, external equity). The weights are the percentages of the different types of capital the firm plans to use when it raises capital in the future. Target weights may differ from actual current weights.

? , or overall, cost of capital.

The target proportions of debt?, preferred stock?, and common equity?, along with the costs of those components, are used to calculate the firm?s?weighted average cost of capital, WACC. We assume at this point that all new common equity is raised as retained earnings, as is true for most companies; hence, the cost of common equity is?:

10.1

Note that only debt has a tax adjustment factor, (1 ? T). As discussed in the next section, this is because interest on debt is tax deductible, but preferred dividends and the returns on common stock (dividends and capital gains) are not.

These definitions and concepts are discussed in the remainder of the chapter, using Allied Food for illustrative purposes. Later in?Chapter 13, we extend the discussion to show how the optimal mix of securities minimizes the firm?s cost of capital and maximizes its value.

Cost of Debt,?

The interest rate a firm must pay on its?new?debt is defined as its?before-tax cost of debt,?. Firms can estimate??by asking their bankers what it will cost to borrow or by finding the yield to maturity on their currently outstanding debt (as we illustrated inChapter 7).?However, the?after-tax cost of debt,?,?should be used to calculate the weighted average cost of capital.?This is the interest rate on new debt,?, less the tax savings that result because interest is tax deductible:

10.2

In effect, the government pays part of the cost of debt because interest is tax deductible. Therefore, if Allied can borrow at an interest rate of 10%, and its marginal federal-plus-state tax rate is 40%, its after-tax cost of debt will be 6%:

We use the after-tax cost of debt in calculating the WACC because we are interested in maximizing the value of the firm?s stock, and the stock price depends on?after-tax?cash flows. Because we are concerned with after-tax cash flows and because cash flows and rates of return should be calculated on a comparable basis, we adjust the interest rate downward due to debt?s preferential tax treatment.

It is important to emphasize that the cost of debt is the interest rate on?new?debt, not outstanding debt. We are interested in the cost of new debt because our primaryconcern with the cost of capital is its use in capital budgeting decisions. For example, would a new machine earn a return greater than the cost of the capital needed to acquire the machine? The rate at which the firm has borrowed in the past is irrelevant when answering this question because we need to know the cost of?new capital. For these reasons, the yield to maturity on outstanding debt (which reflects current market conditions) is a better measure of the cost of debt than the coupon rate.?Note that if the yield curve is upward or downward sloping, the cost of long- and short-term debt will differ. In these cases, the yield to maturity on the company?s long-term debt is generally used to calculate the cost of debt because, more often than not, the capital is being raised to fund long-term projects. ?However, as we see in?Chapter 15, some companies regularly use a mix of short-term and long-term debt to finance their projects. When calculating their costs of debt, these companies may choose to calculate an average of their debt costs based on the proportion of long- and short-term debt that they plan to use.

10-4Cost of Preferred Stock,?

The component?cost of preferred stock,?, used to calculate the weighted average cost of capital is the preferred dividend,?, divided by the current price of the preferred stock,?:

10.3

Allied does not have any preferred stock outstanding, but the company plans to issue some in the future and therefore has included it in its target capital structure. Allied would sell this stock to a few large hedge funds, the stock would have a $10.00 dividend per share, and it would be priced at $97.50 a share. Therefore, Allied?s cost of preferred stock would be 10.3%:

As we can see from?Equation 10.3, calculating the cost of preferred stock is easy. This is particularly true for traditional ?plain vanilla? preferred that pays a fixed dividend in perpetuity. However, in?Chapter 9, we noted that some preferred issues have a specified maturity date and we described how to calculate the expected return on these issues. Also, preferred stock may include an option to convert to common stock, which adds another layer of complexity. We leave these more complicated situations for advanced classes. Finally, note that no tax adjustments are made when calculating??because preferred dividends, unlike interest on debt, are?not?tax deductible, so no tax savings are associated with preferred stock.

10-5The Cost of Retained Earnings,?

The costs of debt and preferred stock are based on the returns that investors require on these securities. Similarly, the cost of common equity is based on the rate of return that investors require on the company?s common stock. Note, though, that new common equity is raised in two ways: (1) by retaining some of the current year?s earnings and (2) by issuing new common stock. ?We use the symbol??to designate the?cost of retained earnings?and??to designate the?cost of new common stock, or external equity. Equity raised by issuing stock has a higher cost than equity from retained earnings due to the flotation costs required to sell new common stock. Therefore, once firms get beyond the start-up stage, they normally obtain all of their new equity by retaining earnings.

Some have argued that retained earnings should be ?free? because they represent money that is ?left over? after dividends are paid. Although it is true that no direct costs are associated with retained earnings, this capital still has a cost, an?opportunity cost.The firm?s after-tax earnings belong to its stockholders. Bondholders are compensated by interest payments; preferred stockholders, by preferred dividends. But the net earnings remaining after paying interest and preferred dividends belong to the common stockholders, and these earnings serve to compensate them for the use of their capital. The managers, who work for the stockholders, can either pay out earnings in the form of dividends or retain earnings for reinvestment in the business. When managers make this decision, they should recognize that there is an opportunity cost involved?stockholders could have received the earnings as?dividends and invested this money in other stocks, in bonds, in real estate, or in anything else.?Therefore, the firm needs to earn at least as much on any earnings retained as the stockholders could earn on alternative investments of comparable risk.

What rate of return can stockholders expect to earn on equivalent-risk investments? First, recall from?Chapter 9?that stocks are normally in equilibrium, with expected and required rates of return equal:?. Thus, Allied?s stockholders expect to be able to earn??on their money.?Therefore, if the firm cannot invest retained earnings to earn at least?, it should pay those funds to its stockholders and let them invest directly in stocks or other assets that will provide that return.

Whereas debt and preferred stocks are contractual obligations whose costs are clearly stated within the contracts, stocks have no comparable stated cost rate. That makes it difficult to measure?. However, we can employ the techniques developed in?Chapters 8and?9?to produce reasonably good estimates of the cost of equity from retained earnings. To begin, recall that if a stock is in equilibrium, its?required rate of return,?, must be equal to its?expected rate of return,?. Further, its?required return?is equal to a risk-free rate,?, plus a risk premium, RP, whereas the?expected return?on the stock is its expected dividend yield,?, plus its expected growth rate, g. Thus, we can write the following equation and estimate??using the left term, the right term, or both terms:

10.4

The left term is based on the capital asset pricing model (CAPM) as discussed in?Chapter 8, and the right term is based on the discounted dividend model as developed in?Chapter 9. We discuss these two procedures, in addition to one based on the firm?s own cost of debt, in the following sections.

10-5AThe CAPM Approach

The most widely used method for estimating the cost of common equity is the capital asset pricing model (CAPM) as developed in?Chapter 8. ?Here are the steps used to find:

? Step?1

Estimate the risk-free rate,?. We generally use the 10-year Treasury bond rate as the measure of the risk-free rate, but some analysts use the short-term Treasury bill rate.

? Step?2

Estimate the stock?s beta coefficient,?, and use it as an index of the stock?s risk. The?i?signifies the?ith company?s beta.

? Step?3

Estimate the market risk premium. Recall that the market risk premium is the difference between the return that investors require on an average stock and the risk-free rate.

? Step?4

Substitute the preceding values in the CAPM equation to estimate the required rate of return on the stock in question:

10.5

Thus, the CAPM estimate of??is equal to the risk-free rate,?, plus a risk premium that is equal to the risk premium on an average stock,?, scaled up or down to reflect the particular stock?s risk as measured by its beta coefficient,?.

Assume that in today?s market,?, the market risk premium is?, and Allied?s beta is 1.48. Using the CAPM approach, Allied?s cost of equity is estimated to be 13.0%:

Although the CAPM appears to produce an accurate, precise estimate of?, several potential problems exist. First, as we saw in?Chapter 8, if a firm?s stockholders are not well diversified, they may be concerned with?stand-alone risk?rather than just market risk. In that case, the firm?s true investment risk would not be measured by its beta and the CAPM estimate would understate the correct value of?. Further, even if the CAPM theory is valid, it is hard to obtain accurate estimates of the required inputs because (1) there is controversy about whether to use long-term or short-term Treasury yields for?. (2) It is hard to estimate the beta that investors expect the company to have in the future. (3) It is difficult to estimate the proper market risk premium. As we indicated earlier, the CAPM approach is used most often; but because of the just-noted problems, analysts also estimate the cost of equity using the other approaches discussed in the following sections.

10-5BBond-Yield-Plus-Risk-Premium Approach

In situations where reliable inputs for the CAPM approach are not available, as would be true for a closely held company, analysts often use a somewhat subjective procedure to estimate the cost of equity. Empirical studies suggest that the risk premium on a firm?s stock over its own bonds generally ranges from 3 to 5 percentage points. ?Based on this evidence, one might simply add a judgmental risk premium of 3% to 5% to the interest rate on the firm?s own long-term debt to estimate its cost of equity. Firms with risky, low-rated, and consequently high-interest-rate debt also have risky, high-cost equity; and the procedure of basing the cost of equity on the firm?s own readily observable debt cost utilizes this logic. For example, given that Allied?s bonds yield 10%, its cost of equity might be estimated as follows:

The bonds of a riskier company might have a higher yield, 12%, in which case the estimated cost of equity would be 16%:

Because the 4% risk premium is an estimate based on judgment, the estimated value of??is also judgmental. Therefore, one might use a range of 3% to 5% for the risk premium and obtain a range of 13% to 15% for Allied. Although this method does not produce a precise cost of equity, it should ?get us in the right ballpark.?

10-5CDividend-Yield-Plus-Growth-Rate, or Discounted Cash Flow (DCF), Approach

In?Chapter 9, we saw that both the price and the expected rate of return on a share of common stock depend, ultimately, on the stock?s expected cash flows. For companies that are expected to remain in business indefinitely, the cash flows are the dividends; on the other hand, if investors expect the firm to be acquired by some other company or to be liquidated, the cash flows will be dividends for some number of years plus a price at the horizon date when the firm is expected to be acquired or liquidated. Like most firms, Allied is expected to continue indefinitely, in which case the following equation applies:

10.6

Here??is the current stock price,??is the dividend expected to be paid at the end of Year t, and??is the required rate of return. If dividends are expected to grow at a constant rate, as we saw in?Chapter 9,?Equation 10.6?reduces to this important formula:

10.7

We can solve for??to obtain the required rate of return on common equity, which for the marginal investor is also equal to the expected rate of return:

10.8

Thus, investors expect to receive a dividend yield,?, plus a capital gain, g, for a total expected return of?; and in equilibrium, this expected return is also equal to the required return,?. This method of estimating the cost of equity is called the?discounted cash flow, or?DCF,?method. Henceforth, we will assume that equilibrium exists, which permits us to use the terms??and??interchangeably.

It is easy to calculate the dividend yield; but because stock prices fluctuate, the yield varies from day to day, which leads to fluctuations in the DCF cost of equity. Also, it is difficult to determine the proper growth rate. If past growth rates in earnings and dividends have been relatively stable, and if investors expect a continuation of past trends, g may be based on the firm?s historic growth rate.?However, if the company?s past growth has been abnormally high or low due to a unique situation or because of general economic fluctuations, investors will not project historical growth rates into the future.?In this case, which applies to Allied, g must be obtained in some other manner.

Security analysts regularly forecast growth rates for earnings and dividends, looking at such factors as projected sales, profit margins, and competition. For example,?Value Line Investment Survey, which is available in most libraries, provides?growth rate forecasts for 1,700 companies; Citigroup, UBS, Credit Suisse, Morgan Stanley, and other organizations make similar forecasts. Averages of these forecasts are available on Yahoo! Finance and other websites. Therefore, someone estimating a firm?s cost of equity can obtain analysts? forecasts and use them as a proxy for the growth expectations of investors in general. Then he or she can combine this g with the current dividend yield to estimate?:

Again, note that this estimate of??is based on the assumption that g is expected to remain constant in the future. Otherwise, we must use an average of expected future rates.

To illustrate the DCF approach, Allied?s stock sells for $23.06; its next expected dividend is $1.25; and analysts expect its growth rate to be 8.3%. Thus, Allied?s expected and required rates of return (hence, its cost of retained earnings) are estimated to be 13.7%:

Based on the DCF method, 13.7% is the minimum rate of return that should be earned on retained earnings to justify plowing earnings back into the business rather than paying them out to shareholders as dividends. Put another way, because investors are thought to have an?opportunity?to earn 13.7% if earnings are paid out as dividends, theopportunity cost?of equity from retained earnings is 13.7%.

10-5DAveraging the Alternative Estimates

In our examples, Allied?s estimated cost of equity was 13.0% by the CAPM, 14.0% by the bond-yield-plus-risk premium method, and 13.7% by the DCF method. Which method should the firm use? If management has confidence in one method, it would probably use that method?s estimate alone. Otherwise, it might use some weighted average of the three methods.

As consultants, we have estimated companies? costs of capital on numerous occasions. We generally take into account all three methods, but we rely most heavily on the method that seems best under the circumstances. Judgment is important and comes into play here, as is true for most decisions in finance. Also, we recognize that our final estimate will almost certainly be incorrect to some extent. ?Therefore, we always provide a range and state that in our judgment, the cost of equity is within that range. For Allied, we used a range of 13% to 14%;?the company then used 13.5% as the estimate of its cost of retained earnings when it calculated its WACC:

Final estimate of??used to calculate Allied?s WACC: 13.5%

Cost of New Common Stock,?

Companies generally use an investment banker when they issue new common stock and sometimes when they issue preferred stock or bonds. In return for a fee, investment bankers help the company structure the terms, set a price for the issue, and sell the issue to investors. The bankers? fees are called?flotation costs, and the total cost of the capital raised is the investors? required return plus the flotation cost.

For most firms at most times, equity flotation costs are not an issue because most equity comes from retained earnings. Therefore, in our discussion to this point, we have ignored flotation costs. However, flotation costs can often be substantial. So if a firm does plan to issue new stock, these costs should not be ignored. When firms use investment bankers to raise capital, two approaches can be used to account for flotation costs. ?We describe them in the next two sections.

Add Flotation Costs to a Project?s Cost

In the next chapter, we show that capital budgeting projects typically involve an initial cash outlay followed by a series of cash inflows. One approach to handling flotation costs, found as the sum of the flotation costs for the debt, preferred, and common stock used to finance the project, is to add this sum to the initial investment cost. Because the investment cost is increased, the project?s expected rate of return is reduced. For example, consider a 1-year project with an initial cost (not including flotation costs) of $100 million. After 1 year, the project is expected to produce an inflow of $115 million. Therefore, its expected rate of return is?. However, if the project requires the company to?raise $100 million of new capital and incur $2 million of flotation costs, the total upfront cost will rise to $102 million, which will lower the expected rate of return to?.

10-6BIncrease the Cost of Capital

The second approach involves adjusting the cost of capital rather than increasing the project?s investment cost. If the firm plans to continue using the capital in the future, as is generally true for equity, this second approach theoretically will be better. The adjustment process is based on the following logic. If there are flotation costs, the issuing firm receives only a portion of the capital provided by investors, with the remainder going to the underwriter. To provide investors with their required rate of return on the capital they contributed, each dollar the firm actually receives must ?work harder?; that is, each dollar must earn a higher rate of return than the investors? required rate of return. For example, suppose investors require a 13.7% return on their investment, but flotation costs represent 10% of the funds raised. Therefore, the firm actually keeps and invests only 90% of the amount that investors supplied. In that case, the firm must earn about 14.3% on the available funds in order to provide investors with a 13.7% return on their investment. This higher rate of return is the flotation-adjusted cost of equity.

The DCF approach can be used to estimate the effects of flotation costs. Here is the equation for the?cost of new common stock,?:

10.9

Here?F?is the percentage?flotation cost?required to sell the new stock, so??is the net price per share received by the company.

Assuming that Allied has a flotation cost of 10%, its cost of new common equity,?, would be calculated as follows:

This is 0.6% higher than the previously estimated 13.7% DCF cost of equity, so theflotation cost adjustment?is 0.6%:

The 0.6% flotation cost adjustment can be added to the previously estimated?(Allied management?s estimate of its cost of equity considering all three approaches), resulting in a cost of equity from new common stock, or external equity, of 14.1%:

If Allied earns 14.1% on funds obtained from selling new stock, the investors who purchased that stock will end up earning 13.5%, their required rate of return, on the money they invested. If Allied earns more than 14.1%, its stock price should rise; but the price should fall if Allied earns less than 14.1%.

When Must External Equity Be Used?

Because of flotation costs, dollars raised by selling new stock must ?work harder? than dollars raised by retaining earnings. Moreover, because no flotation costs are involved, retained earnings cost less than new stock. Therefore, firms should utilize retained earnings to the greatest extent possible. However, if a firm has more good investment opportunities than can be financed with retained earnings plus the debt and preferred stock supported by those retained earnings, it may need to issue new common stock. The total amount of capital that can be raised before new stock must be issued is defined as the?retained earnings breakpoint, and it can be calculated as follows:

10.10

Allied?s addition to retained earnings in 2017 is expected to be $66 million (as we will see la