Financial Modeling Chapter 2 Calculating Cost of Capital 2015
Financial Modeling Chapter 2 Calculating Cost of Capital 2015
To accompany
Financial Modeling, 3rd Edition
Simon Benninga
MIT Press, 2008
FCFt
1 WACC 1 WACC
0.5
t
t 1
Can be computed with
FM3: Chapter 2 Excel's
Cost ofNPV formula
capital 4
Bad news for El Salvador
Only U.S., Europe, can you do this
Means: Everyone bases calculations on U.S.
Typical: “My company in E.S. looks like”
[Intel, GM, Courier, Taco Bell] “therefore …”
Even in U.S., hard calculation
E rM
WACC rf Asset rf
FM3: Chapter 2 Cost of capital 9
Problems with asset beta
How is debt beta D determined?
A technique can be seen in almost all finance
text book, but it is very tedious and probably not
worthwhile for this purpose (it’s a neat
technique to determine the expected return on a
bond!)
In practice: most professors seem to use either
D=0.2 or D=0 (without much justification)
FM3: Chapter 2 Cost of capital 10
D in principle
Suppose you knew the expected return on debt, E(rD).
Then
E rD rf D E rM rf
E rD rf
D
E rM rf
13
Back to five problems:
Finding market value of debt, D
D
Should be: market price of firm’s debts
Almost always replaced by book value of firm’s debts
Reasons
o Most firms have many kinds of debt
o Much debt (most?) is not listed on a market
o Difficult to value debt
o Maybe it doesn’t matter much!
14
D: one more note
For
WACC purposes, Debt = net debt
D=Debt – cash & marketable securities
◦ Exception: where cash needed for production
◦ Exception: banks (Chapter 5)
A B C
1 THE GORDON MODEL COST OF EQUITY
2 Current share price, P0 60
3 Current dividend, D0 3
4 Anticipated dividend growth rate 12%
5 Gordon model cost of equity, rE 17.60% <-- =B3*(1+B4)/B2+B4
P0
1 rE 1 rE 1 rE 1 rE
2 3 4
Div0 * 1 g Div0 * 1 g
t
t 1 1 rE
t
rE g
Div0 * 1 g
Take P0 and solve for rE :
rE g
Div0 * 1 g
rE g
P0
1
JOHNSON & JOHNSON, CASH FLOW TO EQUITY, 1995-2005
Repurchase of Cash flow to Year on
Year ending Dividends Stock issues
2 common stock equity year growth
3 31-Dec-95 827,000,000 322,000,000 -112,000,000 1,037,000,000 <-- =SUM(B3:D3)
4 31-Dec-96 974,000,000 412,000,000 -149,000,000 1,237,000,000 19.29% <-- =E4/E3-1
5 31-Dec-97 1,137,000,000 628,000,000 -225,000,000 1,540,000,000 24.49% <-- =E5/E4-1
6 31-Dec-98 1,305,000,000 930,000,000 -269,000,000 1,966,000,000 27.66% <-- =E6/E5-1
7 31-Dec-99 1,479,000,000 840,000,000 -221,000,000 2,098,000,000 6.71%
8 31-Dec-00 1,724,000,000 973,000,000 -387,000,000 2,310,000,000 10.10%
9 31-Dec-01 2,047,000,000 2,570,000,000 -514,000,000 4,103,000,000 77.62%
10 31-Dec-02 2,381,000,000 6,538,000,000 -390,000,000 8,529,000,000 107.87%
11 31-Dec-03 2,746,000,000 1,183,000,000 -311,000,000 3,618,000,000 -57.58%
12 31-Dec-04 3,251,000,000 1,384,000,000 -642,000,000 3,993,000,000 10.36%
13 31-Dec-05 3,793,000,000 1,717,000,000 -696,000,000 4,814,000,000 20.56%
14
15 End 2005 equity data
16 Stock price 61.07
17 Number of shares 3,119,842,000
18 Equity value 190,528,750,940 <-- =B16*B17
19
20 Equity cash flow, end 2005 4,814,000,000 <-- =E13
21 Future growth rate
22 Based on 10-year growth rate 16.59% <-- =(E13/E3)^(1/10)-1
23 Based on 5-year growth rate 15.82%
24
25 Gordon cost of equity, rE
26 Based on 10-year growth rate 19.54% <-- =B20*(1+B22)/B18+B22
27 Based on 5-year growth rate 18.75% <-- =B20*(1+B23)/B18+B23
8,000,000,000
7,000,000,000
Total dividends
6,000,000,000
Stock repurchases
5,000,000,000 Stock issues
Cash flow to equity
4,000,000,000
3,000,000,000
2,000,000,000
1,000,000,000
0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
-1,000,000,000
Div0 * * 1 1 r
make 1 rE E
1
Divm * (1 g 2 )t
these 1
1 g1 1 rE
m
t 1 1 rE
t
1 rE
two
1 g1 1 g1
m
equal Div0 * * 1 1 r
1 rE E Div0 1 g1 1 g2
m
1
1 g1 1 rE
m
rE g 2
1
1 rE
A B C
In te l re tu r n s
27 1-Apr-02 27.44 1076.92 -6.11% -6.34%
-25%
28 1-May-02 26.51 1067.14 y = 2.2516x
-3.45% -0.91%- 0.0029
-41.30% R -7.52%
= 0.5304
2
29 3-Jun-02 17.54 989.82
30 1-Jul-02 18.04 911.62 -35% 2.81% -8.23%
31 1-Aug-02 16.02 916.07 -11.88% 0.49%
32 3-Sep-02 13.35 815.28 -45% -18.23% -11.66%
33 1-Oct-02 16.62 885.76 21.91% 8.29%
34 1-Nov-02 20.09 936.31 18.96% 5.55%
35 2-Dec-02 14.98 879.82 FM3: Chapter 2 Cost
-29.35% of capital
-6.22% 37
CAPM issues
rf : short-term or long-term
Short-term
E(rM) ?
Historical average of market returns
Forward-looking using Gordon E(rM) P/E formula
Incorporating taxes into SML
rE rf 1 TC
E rM rf 1 TC
1
KRAFT: COST OF EQUITY rE BASED ON CASH FLOW TO EQUITY
2 Shares outstanding 1,669,880,755
3 Share price, end 2005 27.75
4 Equity value, E 46,339,190,951 <-- =B2*B3
5 End 2005 total equity payout 2,612,000,000 <-- =E18
6
7 High growth rate, ghigh 10.00% <-- Guess
8 Number of high-growth years 3 <-- Guess
9 Normal growth rate, gnormal 6% <-- Guess
10
Cost of equity, rE, using the
11 function twostagegordon 12.64% <-- =twostagegordon(B4,B5,B7,B8,B9)
12
Stock Cash flow to
Dividends paid Stock issuance
13 Date repurchases equity holders
14 31-Dec-01 170,000,000 225,000,000 395,000,000 <-- =B14+C14-D14
15 31-Dec-02 372,000,000 936,000,000 8,425,000,000 -7,117,000,000 <-- =B15+C15-D15
16 31-Dec-03 372,000,000 1,089,000,000 1,461,000,000
17 31-Dec-04 688,000,000 1,280,000,000 1,968,000,000
18 31-Dec-05 1,175,000,000 1,437,000,000 2,612,000,000
19 Growth rates
20 Four year 62.14% 58.97% 60.36% <-- =(E18/E14)^(1/4)-1
21 Two year 77.72% 14.87% 33.71% <-- =(E18/E16)^(1/2)-1
1
TYSON: COST OF EQUITY rE BASED ON CASH FLOW TO EQUITY
2 Shares outstanding 354,820,000
3 Share price, 11Aug06 13.45
4 Equity value, E 4,772,329,000 <-- =B2*B3
5 Current (Aug06) total equity payout 81,631,562 <-- =E18*(1+B7)^0.75
6
7 High growth rate, ghigh 10.00% <-- Guess
8 Number of high-growth years 3 <-- Guess
9 Normal growth rate, gnormal 2% <-- Guess
10
Cost of equity, rE, using the function
11 twostagegordon 4.18% <-- =twostagegordon(B4,B5,B7,B8,B9)
12
Stock Cash flow to
Dividends paid Stock issuance
13 Date repurchases equity holders
14 2001 48,000,000 35,000,000 34,000,000 49,000,000 <-- =B14+C14-D14
15 2002 19,000,000 58,000,000 0 77,000,000 <-- =B15+C15-D15
16 2003 41,000,000 54,000,000 0 95,000,000
17 2004 72,000,000 55,000,000 43,000,000 84,000,000
18 2005 45,000,000 55,000,000 24,000,000 76,000,000
19 Growth rates
20 Four year -1.60% 11.96% 11.60% <-- =(E18/E14)^(1/4)-1
21 Two year 4.76% 0.92% -10.56% <-- =(E18/E16)^(1/2)-1
1
CASCADE: COST OF EQUITY r E BASED ON CASH FLOW TO EQUITY
2 Shares outstanding 12,536,000
3 Share price, 31jan06 50.69
4 Equity value, E 635,449,840 <-- =B2*B3
5 2005 total equity payout 3,904,000 <-- =E16
6 Growth rate of payouts 9.78% <-- =E17
7 Cost of equity, rE 10.46% <-- =B5*(1+B6)/B4+B6
8
9
Stock Cash flow to
Dividends paid Stock issuance
10 Date repurchases equity holders
11 1/31/2001 0 2,448,000 2,448,000
12 1/31/2002 1,354,000 0 1,354,000
13 1/31/2003 1,396,000 1,200,000 73,000 2,523,000
14 1/31/2004 0 4,936,000 1,299,000 3,637,000
15 1/31/2005 5,478,000 1,616,000 3,862,000
16 1/31/2006 6,691,000 2,787,000 3,904,000
17 Growth rate 9.78% <-- =(E16/E11)^(1/5)-1
Average of Gordon/payout,
14 Cost of equity, r E 10.46% <-- ='Cascade equity payouts and rE'!B7
15 Cost of debt, r D 7.78% <-- ='Cascade cost of debt'!B15
16 Tax rate, T C
17 WACC
32.42% <-- ='Cascade rE, CAPM'!B9
CAPM/Classic, and CAPM/tax-
10.70% <-- =$B$4/($B$4+$B$5)*B14+$B$5/($B$4+$B$5)*B15*(1-B16)
18
19 WACC based on classic CAPM and interest from financial statements
20 Cost of equity, r E 11.55%
adjusted. Gordon/dividend is
21 Cost of debt, r D
22 Tax rate, T C
7.78%
32.42%
out-of-line.
23 WACC 11.85% <-- =$B$4/($B$4+$B$5)*B20+$B$5/($B$4+$B$5)*B21*(1-B22)
24
WACC=11.83%
25 WACC based on tax-adjusted CAPM and interest from financial statements
26 Cost of equity, r E 12.59%
27 Cost of debt, r D 7.78%
28 Tax rate, T C 32.42%
29 WACC 12.94% <-- =$B$4/($B$4+$B$5)*B26+$B$5/($B$4+$B$5)*B27*(1-B28)
30
31 Estimated WACC? 11.83% <-- =AVERAGE(B29,B23,B17)
64