AFM 373 Lecture 8 Weighted Average Cost of Capital (WACC)

ACC 690 – Course Overview 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.

Introduction; Managing C/A; Cash Flow Forecasting Managing C/L; Issuing Short Term Debt & ABL Issuing LTD; Debt Ratings; Debt Covenants Issuing Equity; IPO‟s, PE, VC Wtd. Average Cost of Capital; Determining Capital Structure Valuation Overview; Intro to M&A Mergers & Acquisitions - Structure; Leveraged Buyouts Mergers & Acquisitions - Process; Due Diligence Capital Budgeting; Lease vs. Buy/Borrow Financial Distress & Turnarounds Financial Risk Management & Derivative Use Dividend & Payout Policy; Managing Corporate Investments 2

Weighted Average Cost of Capital (WACC) •

The weighted average cost of capital (WACC) serves three primary purposes: 1. To evaluate capital project proposals. 2. To set performance targets for management to sustain or grow market values, and 3. To measure management performance.

Steps in Solving for the WACC 1. Identify the sources of capital (Debt and Equity). 2. Estimate the market values for each source of capital and determine the market value weights. 3. Estimate the marginal, after-tax, and afterfloatation cost for each source of capital. 4. Calculate the weighted average.

What is Included in WACC ? • Cost of Each Type of Capital for the Company, proportionally weighted, typically including: • Debt Costs: • Bank loans • Long-term debt – bonds/debentures

• Equity Costs: • Preferred equity costs • Common equity costs

Weighted Average Cost of Capital - WACC

E D PS       WACC  K e    Kd    K ps    D  E  PS   D  E  PS   D  E  PS  • Need to calculate for each type of capital: 1) market value of each type of capital 2) % of each type of capital in total capital, 3) and the respective marginal cost of each (Kd , Ke, K ps)

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Why Use Current Market Rates for each Type of Capital? • The Firm is making a Key Decision NOW • Therefore, the cost of capital 5 months, 5 years or 5 decades ago is irrelevant. • What is relevant NOW is the rate that each type of capital costs in today‟s economic environment for this particular firm. • Sometimes called the “Marginal” Cost of Capital

Cost of Debt - Kd • This is the current cost to the firm for borrowing funds based on:

• Current interest rate levels • Default risk of company • Tax Shield from Interest 8

Importance of Tax Deductibility of Interest Key Concept: in WACC equation Kd - is after tax cost of debt, reflecting that interest is tax deductible

Therefore Kd = rd(1-t) Where: rd= pre-tax cost of Debt t = Marginal tax rate of the firm( Fed+ Prov.) 9

WACC- Simple Capital Structure

Once you have the specific marginal costs of capital (after ing for taxes and floatation costs) and you have found the appropriate weights to use, the actual calculation of a WACC is a simple matter.

S D WACC  K a  K e    K d (1  T )  V  V  The cost of equity times the market value weight of equity

The cost of debt after tax times the market value weight of debt

Weighting Each Capital Component • Each Type of Equity would have its own weighting component • Each Types of Debt would have its own weighting component

WACC - Spreadsheet Example

(1)

Type of Capital Long-Term Debt Preferred Stock Common Stock

(2)

(3)

(4) = (2)*(3)

Specific Marginal Cost Weighted after tax and Market Specific floatation Value Marginal costs Weights Cost 5.5% 11.4% 12.9%

43.0% 11.0% 46.0% WACC =

0.02365 0.01254 0.05934 9.55%

WACC is the sum of the weighted specific marginal costs of each source of capital.

Determining - Current Market Value of a Bond • Requires market value of debt (not book value) Coupon face value of bond Mkt Value of Corporate Bond    t N t 1 (1  r ) (1  r ) d d tN

• rd =

the market rate of debt given default risk (not necessarily

the coupon rate, but the current market rate for that company to issue at)

• This is the rate that you discount back the cash flows at.

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Cost of Preferred Equity • If viewed preferred as perpetual, has a fixed dividend, (PV of a perpetuity formula) …… • Preferred Share dividends are paid from after tax dollars - (do not tax effect the rate) K ps 

dividend per share (or total dividend) market price of pref

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Market Value of Common Equity For a Public company: = # of common shares O/S X current stock price If there are warrants and options, ( in the money) you must calculate the “equity like options‟” current market value and add to common equity value

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Market Value of Common Equity • Cost of Equity may be observable in the Market, through comparable securities. • Various models can be used to estimate Cost of Equity. • We will emphasize Capital Asset Pricing Model (CAPM). According to some studies 80%+ use this method.

• Originated by Prof. William Sharpe, Stanford U. in 1964 • For his work on CAPM, Sharpe shared the 1990 Nobel Prize in Economics with Markowitz and Miller. 16

Capital Asset Pricing Model (CAPM) [calculating the Ke]

K j  RF  ( E( RM )  RF ) j Risk Free Rate Expected Rate of Return or E(Re)

Market Risk RM= Expected Return on Market “Systematic” risk of individual security - tendency of the security to move with all the other securities in the market and by how much 17

Risk-Based Models and the Cost of Common Equity Using the CAPM to Estimate the Cost of Common Equity

• CAPM can be used to estimate the required return by common shareholders. • It can be used in situations where DCF methods will perform poorly (growth firms) • CAPM estimate is a „market determined‟ estimate because: – The RF (risk-free) rate is the benchmark return and is measured directly, today as the yield on 91-day T-bills – The market for risk (MRP) is taken from current market estimates of the overall return in the market place less RF (ERM – RF)

Risk-Based Models and the Cost of Common Equity Using the CAPM to Estimate the Cost of Common Equity •

As a single-factor model, we estimate the common shareholder‟s required return based on an estimate of the systematic risk of the firm (measured by the firm‟s beta coefficient)

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•

K e  RF  MRP   e

Where: Ke = investor‟s required rate of return βe = the stock’s beta coefficient Rf = the risk-free rate of return MRP = the market risk (ERM - Rf )

Risk-Based Models and the Cost of Common Equity Estimating the Market Risk

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K e  RF  MRP   e

• Rf is ‘observable’ (yield on 10+ year Gov’t Bonds) • Not T-bill rates • Getting an estimate of the market risk is one of the more difficult challenges in using this model. – We really need a „forward‟ looking of MRP or a „forward‟ looking estimate of the ERM

• One approach is to use an estimate of the current, expected MRP by examining a long-run average that prevailed in the past.

Canadian Market Risk (MRP) (1938-2005) Average Investment

Return

Canada T-Bills

5.20%

Canada Bonds

6.62%

Canadian Stocks

11.79%

U.S. Stocks

13.15%

Stock returns exceeded Bond returns by 5.17% Source: Booth & Cleary ; data from Canadian Institute of Actuaries

The consensus is that the Canadian MRP over the long-term bond yield is between 4.0 and 5.5%. 21

Cost of Common Equity Estimating Beta • After obtaining estimates of the two important market rates (Rf and MRP), an estimate for the company beta is required. • In some cases, Beta may have to be unlevered and re-levered? • Why ?

Unlevering and Re-levering Beta • If the debt level changes dramatically, beta for Equity may have to be re-calculated. • For example, a significant new Debt issuance, or a large Debt repayment.

• Why ? • The main impact of leverage on WACC is the interest tax shield.

Unlevering and Re-levering Beta • We can unlever and relever Beta using the “Hamada Equation” (there are several others that serve the purpose). • Hamada essentially combined the effects of CAPM with M&M theory. • Assumes constant amount of debt (vs. constant D/E) • It separates out the effect of financial leverage from the underlying business risk of the firm by comparing a firm with an unlevered counterpart.

Unlevering and Re-levering Beta an Example going from D/E of 1.5 to 4.0 ( assume a 35% Tax rate) BL =BU * (1+ (D/E*(1-T)) BU = BL / (1+ (D/E*(1-T))

If Original D / (D+E) =.60 Then D / E= .60 /.40 (i.e. 1.5:1) Original Levered Beta = 1.25 Then Bu = 1.25 / 1+(60/.40) *(1-.35) Bu= 1.25 / 1.975 Bu=.63

Re-levering Beta- Example Going from D/E of 1.5:1 to 4:1 with 35% Tax Rate BL =BU (1+ (D/E)*(1-T)) BU = BL / (1+ (D/E) *(1-T)) New D / (D+E) =.80 Then D / E= .80 /.20 (4:1) Then New Levered Beta is Then BL = .63 *(1+(1-.35)*.80/.20) BL= .63 * 2.6 BL= 1.64

Re-levering Beta- Example with 35% Tax Rate

• Now, use the new levered Beta to determine revised Ke and WACC!

Preferred Shares – General Features • Shares can have a number of designations – common, ordinary, Class A and preferred • Preferred shares typically occupy a position between the companies creditors and common shares – They have a prior claim on assets ahead of common shares in a windup or dissolution of the company – Prefs are usually entitled to a fixed dividend payment out of net earnings – Cumulative Feature - dividends do not have to be paid, but if skipped unpaid dividends accumulate. – Most are non-voting, unless a certain number of dividends have been missed (typically 8 quarterly) ; then they have voting privileges – There is no maturity date – Prefs do not have a trust indenture (like debt does). The description of preferreds is in the company‟s charter – There are many different features that preferred shares can have, some strengthen the issuer‟s position and others protect the purchaser

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Preferred Shares - From an Issuer’s Perspective • Issuer‟s perspective - Prefs are debt that get treated as equity from rating agencies and regulators – the dividend can be suspended - unlike debt, where the co. would go into default – dividend is paid out of after tax dollars, same as a regular common share dividend

• Motivation to Issue Preferred Shares - overall two main types of issuers: i) Corporations that are regulated a) firm‟s want more equity but regulator says no- ie company that has rate of return considerations b) regulator wants firm to have more equity than they wish ii) Corporations trying to maintain a debt rating (avoid a lower rating), or corporations that do not want dilution of have control issues

• Many features and options - flavour of the times: hard retraction, soft retraction, redeemable, auction set • Currently Issuers are - approximately 30% Financial Institutions, 50% utilities, 20 % industrials 29

Preferred Share Features • Most preferreds have a fixed dividend expressed as a % of par or a stated value

• e.g. 8% of par or $2.00 (“par” is typically $25) Other Common Features •

•

•

Convertible – the holder can convert the pref into common shares at a predetermined price (conversion price) for a certain time period. Once the underlying common reaches that level the pref‟s price starts to reflect the common stock‟s mkt price Redeemable – most convertible prefs are redeemable – which gives the issuer the right to force conversion into the underlying shares, when the market price of these shares is above the conversion price. Retractable – means the holder can require the company to buy back the retractable preferred on a specified date(s) and at a predetermined price (retraction price)

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Preferred Shares - Investor Perspective Dividend Tax Credit Because dividends are paid from a company‟s after tax earnings the government gives investors a bit of a tax break (ie pay less tax on dividends) – Dividend Tax Credit: dividends are taxed at a lower rate – The calculation (which is confusing) consists of gros the amount of dividend by 25%, calculating the federal taxes and deducting a federal tax credit of 16.667% of dividend received . The provinces also have their own dividend tax credit for provincial taxes – as a rule of thumb most investors consider preferreds as a debt alternative and gross up Cdn preferred dividends by a set amount in order to equate (compare) returns with those of interest bearing instruments (bonds, GIC‟s)

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Market Value Weights An Example Given:

– Market price for common stock = $21.50 – Bonds are trading for 95% of face value • In order to calculate market value (MV) weights, you will need to know the total market value of debt, and common stock (and preferred stock if the company uses it.) • To calculate total MV you need to know the current price of the security in each class, as well as the total number of securities outstanding: Total Market Capitalization = Price × Quantity

Market Value Weights - Example The following balance sheet date, when combined with market price data, will allow you to calculate MV weights. XYZ Company Limited Balance Sheet as at January 30, 2xxx ASSETS Current Assets Net Fixed Assets

$147,000 15,000,250

LIABILITIES: Current Liabilities 8.5% 2020 Mortgage Bonds

$75,250 4,000,000

Common stock (1,000,000 outstanding) 7,155,000 Retained earnings 3,917,000 TOTAL ASSETS EQUITY

$15,147,250 $15,147,250

TOTAL LIABILITIES AND O.

Face value of bonds are Number of common shares $1,000, therefore there outstanding is read frommust the be 4,000 bondssheet. outstanding. balance

Market Value Weights An Example Continued…

Total MV of Equity = Price per share times number of shares = 1M × $21.50 = $21.5M Total MV of Bonds = Price per bond times number of bonds = $950 × 4,000 = $3,800,000

Type of Capital Bonds Stock

Market Total Market price Number Value $950.00 4,000 $3,800,000 $21.50 1,000,000 $21,500,000 TOTAL= $25,300,000

Market Value Weight 15.02% 84.98% 100.00%

These weights could now be used to calculate WACC.

Bond Value General Formula • •

In the example, you didn‟t have to calculate the bond value because you were given the fact that it was trading at 95% of par. In the event that you do, however, simply use this equation

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1  1   ( 1  k )n b B  I  kb  

  1 F ( 1  kb )n  

Where: I = interest (or coupon ) payments kb = the bond discount rate (or market rate) n = the term to maturity F = Face (or par) value of the bond

Floatation Costs • Issuing or floatation costs are incurred by a firm when it raises new capital through the sale of securities in the primary market. • These costs include: – Underwriting discounts paid to the investment dealer – Direct costs associated with the issue including legal and ing costs

• The result: – Net proceeds on the sale of each security is less than what the investor invests, and – The component cost of capital > investor‟s required return.

Average Floatation Costs Average Issuing Costs Commercial paper Medium-term notes Long-term debt Equity (large) Equity (small) Equity (private)

0.125% 1.0% 2.0% 5.0% 5.0% - 10.0% 10.0% and up

Floatation costs for debt securities is lowest because debt is normally privately placed with large institutional investors not requiring underwriting costs and because debt is either issued by high quality issuers or sits at the top of the priority of claims list in the case of default.

The Component Cost of Debt

• The cost of debt is a function of: – The investor‟s required rate of return – The tax-deductibility of interest expense – The floatation costs incurred to issue new debt

WACC – Common Calculation Errors Cost of Debt

• Any Ideas ??

WACC – Common Calculation Errors Cost of Debt • Must Use Using Market Value of Debt (versus trading at Par 100). • Must use (1-T) to get the after tax cost • Forgetting Floatation Cost

WACC – Common Calculation Errors Cost of Preferred Shares

• Any Ideas ??

WACC – Common Calculation Errors Cost of Pref. Shares • Must Use Market Value of Pref Shares • Divide dividend per share by current market price per pref. share • Forgetting Floatation Cost

WACC – Common Calculation Errors Cost of Common Shares

• Any Ideas ??

WACC – Common Calculation Errors Cost of Common Shares • Must Use Market Value of Common • In CAPM, for Rf, should use Longer Term Gov‟t Debt (10 + Years), not short term T-Bill rates. • Forgetting Floatation Cost

WACC -Summary •

WACC measures the firm‟s cost of financing today, based on current capital market conditions.

•

WACC is the “ Default” Firm‟s “Discount Rate”.

•

WACC is used to make capital investment decisions.

Raptor Industries WACC Problem Review Solution

Determining Capital Structure in Practice

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Leverage in Practice

The tradeoff theory helps explain: • Why firms choose debt levels that are below the maximum, to avoid the costs of financial distress. • Industry differences in the use of leverage because of different financial distress costs and the volatility of cash flows.

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Management of Capital Structure • Needs to be viewed as a dynamic process Too aggressive – can lead to financial distress and bankruptcy Excess conservatism – can put you at a competitive disadvantage by having a higher cost of capital, and may also flag you as a takeover target. • The addition of a reasonable amount of debt to the capital structure can reduce WACC. • Therefore shareholders receive greater – should be reflected in increase stock price. • All of the return, in excess of its WACC, are gains that accrue to common shareholders 4949

Capital Structure in Practice Factors favouring corporate ability and willingness to issue debt: • Capital Market Conditions: Is this a Good Time to Issue Equity? Is this a Good Time to Issue Debt? • Profitability (so the firm can use interest tax shield) • Unencumbered tangible assets to be used as collateral for secured debt. • Stable business operations over time. • Corporate size – larger companies may have greater market acceptance. • Growth rate of the firm. 50

Primary Factors in Determining Debt Level (Deutsche Bank 2006) 1. 2. 3. 4. 5. 6. 7.

Effect on Credit Rating (57%) Ability to Continue Investments (52%) Tax Shield (32%) Ability to Continue Dividends (31%) Market Capacity for our Debt (29%) Debt Transaction Costs (25%) Action of Industry Competitors (20%)

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Limits to Debt

What Factors Limit a Company’s

Use of Debt ?

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Limits to Debt • Covenants in Existing Debt Security re: Maximum Leverage

• Covenants in Existing Debt Security re: Minimum Debt service • High Interest Rates • Ability to Service New Debt from Forecast Cash Flow 15-53