Chapter 14 Cost of Capital Lecture 5

TAXES AND THE WEIGHTED AVERAGE COST OF CAPITAL Aftertax Discount Rate: When calculating discount rates for cash flows, the rates must be expressed on an aftertax basis since we're concerned with aftertax cash flows. Corporate interest payments are tax-deductible, unlike payments to stockholders (e.g., dividends). This means the government effectively subsidizes part of the interest cost by reducing the firm's tax bill. Pretax vs. Aftertax Cost of Debt:  The cost of debt must be adjusted for taxes to determine the aftertax cost.  Since interest is tax-deductible, the aftertax cost is lower than the pretax cost.  Example: A firm borrows $1 million at 9% interest, and with a corporate tax rate of 34%, the aftertax interest rate is reduced to 5.94%.  The formula for aftertax cost of debt is: Aftertax cost of debt=RD×(1−TC) Where RD is the pretax cost of debt, and TC is the corporate tax rate. Tax Savings from Debt:  The tax-deductibility of interest payments results in tax savings. In the example, the $90,000 in interest reduces the firm’s tax bill by $30,600, leading to an actual interest cost of $59,400.  The formula for tax savings is: 𝑇𝑎𝑥 𝑠𝑎𝑣𝑖𝑛𝑔𝑠=𝑇𝐶 × 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 Capital Structure Weights:  When calculating a firm's overall cost of capital (WACC), the aftertax cost of debt is combined with the cost of equity, taking into account the capital structure weights (the proportion of debt and equity financing used by the firm).  The adjusted cost of debt (aftertax) and cost of equity are both factored into determining the overall discount rate used for evaluating projects. To calculate the firm’s overall cost of capital, we multiply the capital structure weights by the associated costs and add them up. The total is the weighted average cost of capital (WACC): The weighted average of the cost of equity and the after-tax cost of debt. +(D/V)) This WACC has a straightforward interpretation.  It is the overall return the firm must earn on its existing assets to maintain the value of its stock.  It is also the required return on any investments by the firm that have essentially the same risks as existing operations.  So, if we were evaluating the cash flows from a proposed expansion of our existing operations, this is the discount rate we would use.  If a firm uses preferred stock in its capital structure, then our expression for the WACC needs a simple extension.  If we define P/V as the percentage of the firm’s financing that comes from preferred stock, then the WACC is simply: + (P/V)) where RP is the cost of preferred stock. CALCULATING THE WACC FOR EASTMAN CHEMICAL Eastman’s Cost of Equity Our first stop is the main screen for Eastman available at finance.yahoo.com (ticker: EMN). As of early 2014, here’s what it looked like:  Next, we went to the “Key Statistics” screen.  According to this screen ,Eastman has 152.42 million shares of stock outstanding.  The book value per share is $24.91, but the stock sells for $86.51.  Total equity is therefore about $3.797 billion on a book value basis, but it is closer to $13.186 billion on a market value basis.  To estimate Eastman’s cost of equity, we will assume a market risk premium of 7 percent, similar to what we calculated in Chapter 12. Eastman’s beta on Yahoo! is 1.80, which is much higher than the beta of the average stock.  To check this number, we went to the well-known Value Line Investment Survey, which uses an approach that moderates very large and very small betas. Here, the beta is reported as a much more reasonable 1.35, which is the number we will use.  According to the Bonds section of finance.yahoo.com, Tbills were paying about .10 percent. Using the CAPM to estimate the cost of equity, we find: RE = .001 + 1.35 (.07) = .0955, or 9.55% Eastman has paid dividends for only a few years, so calculating the growth rate for the dividend discount model is problematic. However, under the Analyst Estimates link at finance.yahoo.com, we found the following:  Solving for RE, we get 7.43 percent.  Notice that our two estimates for the cost of equity are not identical. This is essentially always the case.  Remember that each method of estimating the cost of equity relies on different assumptions, so different estimates of the cost of equity should not surprise us.