Mini-Project 3: Weighted Average Cost of Capital: Find 2012 financial statements
ID: 2702020 • Letter: M
Question
Mini-Project 3: Weighted Average Cost of Capital: Find 2012 financial statements and other financial data (e.g., beta) for the Boeing Company (Stock ticker: BA). from Yahoo! Finance, Google Finance, MSN Money, UHV Online library, or other sources.
(1) Estimate the company%u2019s weights of capital (debt, preferred stock, and common stock).
(2) Estimate the company%u2019s before-tax and after-tax component cost of debt;
(3) Estimate the firm%u2019s component cost of preferred stock;
(4) Estimate the component cost of common equity using CAPM.
(5) Compute the firm%u2019s weighted average cost of capital (WACC).
Explanation / Answer
%uF06E Capital components: debt, preferred stock, and common stock.
%uF06E Any increase in total assets must be financed by an increase in one or more of these capital components
%uF06E Kd: the interest rate on the firm%u2019s new debt
Kps: the cost of preferred stock
Ks: the cost of retained earnings
Ke:the cost of common equity (equity obtained by issuing new common stock as apposed to retaining eanings
1. The cost of debt
Kd(1-T) is the after tax cost of debt. The relevant cost of new debt, taking into account the tax deductibility of interest.
In effect, the government pays part of the cost of debt because interest is deductible.
Note that the cost of debt is the interest rate on new debt, not the interest rate paid on existing or old debt.
A 15-year, 12% semiannual bond sells for $1,153.72. What%u2019s kd?
Component Cost of Debt
%uF06E Interest is tax deductible, so
kd AT = kd BT(1 %u2013 T)
= 10%(1 %u2013 0.40) = 6%.
2. The cost of preferred stock (Kp)
The rate of return investors require on the firm%u2019s preferred stock.
Preferred stock is a perpetuity that pays a fixed dividend (Dp) forever.
Kp = Preferred dividend / the current price of the preferred stock
What%u2019s the cost of preferred stock?
Pp = $111.10; $10 dividend/share
Note:
%uF06E Preferred dividends are not tax deductible, so no tax adjustment. Just kp.
%uF06E Nominal kp is used.
%uF06E Our calculation ignores flotation costs.
Why is there a cost for retained earnings?
%uF06E Earnings can be reinvested or paid out as dividends.
%uF06E Investors could buy other securities, earn a return.
%uF06E Thus, there is an opportunity cost if earnings are retained.
%uF06E Opportunity cost: The return stockholders could earn on alternative investments of equal risk.
%uF06E They could buy similar stocks and earn ks. So, ks is the cost of retained earnings. The rate of return required by stockholders on a firm%u2019s common stock
Three ways to determine cost of common equity, ks:
What%u2019s the cost of common equity based on the CAPM?
kRF = 7%, RPM = 6%, b = 1.2.
What%u2019s the DCF cost of common
equity, ks? Given: D0 = $4.19;
P0 = $50; g = 5%.
Suppose the company has been earning 15% on equity (ROE = 15%) and retaining 35% (dividend payout = 65%), and this situation is expected to continue.
What%u2019s the expected future g?
Retention growth rate:
g = (1 %u2013 Payout)(ROE) = 0.35(15%)
= 5.25%.
Here (1 %u2013 Payout) = Fraction retained.
Find ks using the own-bond-yield-plus-risk-premium method.
(kd = 10%, RP = 4%.)
%uF06E This RP %uF0B9 CAPM RP.
%uF06E Produces ballpark estimate of ks.
What%u2019s a reasonable final estimate of ks?
Why is the cost of retained earnings (ks) cheaper than the cost of issuing new common stock (ke)?
Two approaches that can be used to account for flotation costs:
%uF06E Include the flotation costs as part of the project%u2019s up-front cost. This reduces the project%u2019s estimated return.
%uF06E Adjust the cost of capital to include flotation costs. This is most commonly done by incorporating flotation costs in the DCF model.
%uF06E Ke = [D1/Po(1-F) ] + g
F is the percentage flotation cost required to sell the new stock. So, Po (1-F) is the net price per share received by the company.
Comments about flotation costs:
%uF06E Flotation costs depend on the risk of the firm and the type of capital being raised.
%uF06E The flotation costs are highest for common equity. However, since most firms issue equity infrequently, the per-project cost is fairly small.
%uF06E We will frequently ignore flotation costs when calculating the WACC.
5. Weighted Average Cost of Capital (WACC)
If all new equity will come from retained earnings:
WACC = Wd [Kd(1-t)] + Wp(Kps) + Wc(Ks)
Wd, Ws, Wc are the weights used for debt, preferred stock, and common equity.
Assume that the firm has established such a target and will finance all new investments so as to maintain a constant target capital structure.
Weights should be based on the market value.
What%u2019s the firm%u2019s WACC (ignoring flotation costs)?
%uF06E The company has a target capital structure of 40 percent debt and 60 percent equity
%uF06E Bonds pay 10% coupon (semiannual), mature in 20 years and sell for $849.54
%uF06E the company stock beta is 1.2
%uF06E rf = 10%, market risk premium = 5%
%uF06E the company is a constant growth firm that just paid a dividend of $2, sells for $27 per share, and a growth rate of 8%
%uF06E marginal tax rate is 40%.
What factors influence a company%u2019s composite WACC?
%uF06E Market conditions. (the level of interest rates, tax rates%u2026)
%uF06E The firm%u2019s capital structure and dividend policy.
%uF06E The firm%u2019s investment policy. Firms with riskier projects generally have a higher WACC.
WACC Estimates for Some Large
U. S. Corporations, Nov. 1999
Should the company use the composite WACC as the hurdle rate for each of its projects?
%uF06E NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the %u201Churdle rate%u201D for a typical project with average risk.
%uF06E Different projects have different risks. The project%u2019s WACC should be adjusted to reflect the project%u2019s risk.
What procedures are used to determine the risk-adjusted cost of capital for a particular project or division?
%uF06E Subjective adjustments to the firm%u2019s composite WACC.
%uF06E Attempt to estimate what the cost of capital would be if the project/division were a stand-alone firm. This requires estimating the project%u2019s beta.
Find the division%u2019s market risk and cost of capital based on the CAPM, given these inputs:
%uF06E Target debt ratio = 40%.
%uF06E kd = 12%.
%uF06E kRF = 7%.
%uF06E Tax rate = 40%.
%uF06E betaDivision = 1.7.
%uF06E Market risk premium = 6%.
%uF06E Beta = 1.7, so division has more market risk than average.
%uF06E Division%u2019s required return on equity:
ks = kRF + (kM %u2013 kRF)bDiv.
= 7% + (6%)1.7 = 17.2%.
WACCDiv. = wdkd(1 %u2013 T) + wcks
= 0.4(12%)(0.6) + 0.6(17.2%)
= 13.2%.
How does the division%u2019s market risk compare with the firm%u2019s overall market risk?
%uF06E Division WACC = 13.2% versus company WACC = 11.1%.
%uF06E Indicates that the division%u2019s market risk is greater than firm%u2019s average project.
%uF06E %u201CTypical%u201D projects within this division would be accepted if their returns are above 13.2%.