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THE EXPECTED RETURN ON PREFERRED STOCK

Preferred stock that pays a fixed annual dividend can be valued from the perpetuity formula:

Price of preferred = dividend rpreferred where rpreferred is the appropriate discount rate for the preferred stock. Therefore, we can infer the required rate of return on preferred stock by rearranging the valuation formula to

rpreferred = dividend price of preferred

For example, if a share of preferred stock sells for $20 and pays a dividend of $2 per share, the expected return on preferred stock is rpreferred = $2/$20 = 10 percent, which is simply the dividend yield.

Big Oil`s Weighted-Average Cost of Capital

Now that you have worked out Big Oil`s capital structure and estimated the expected return on its securities, you need only simple arithmetic to calculate the weighted-average cost of capital. Table 4.13 summarizes the necessary data. Now all you need to do is plug the data in Table 4.13 into the weighted-average cost of capital formula:

Suppose that Big Oil needed to evaluate a project with the same risk as its existing business that would also support a 24.3 percent debt ratio. The 11.6 percent weightedaverage cost of capital is the appropriate discount rate for the cash flows.

REAL OIL COMPANY WACCs

Big Oil is entirely hypothetical ¤and not even very big compared to actual oil companies. Figure 4.18 shows estimated average costs of equity (requity) and WACCs for a sample of 10 to 12 large oil companies from 1965 to 1997. The latest estimates seem to fall below 10 percent, less than our hypothetical figure for Big Oil.

The WACC estimates in Figure 4.18 decline steadily since the early 1980s. Some of that decline can be attributed to a decline in interest rates over the 1980s and early 1990s. We have included a plot of the risk-free rate (rf) in Figure 4.18 as a reference point. However, the spread between the WACC estimates and these interest rates has also narrowed, suggesting that investors viewed the oil business as less risky in the early 1990s than a decade earlier.

Remember, the WACCs shown in Figure 4.18 are industry averages and therefore cover a wide range of activities. The large oil companies sampled are involved in some risky activities, such as exploration, and some relatively safe activities, such as franchising retail gas stations. The industry average will not be right for everything the industry does.

Interpreting the Weighted-Average Cost of Capital

WHEN YOU CAN AND CAN`T USE WACC

Earlier discussed the company cost of capital, but at that stage we did not know how to measure the company cost of capital when the firm has issued different types of securities or how to adjust for the tax-deductibility of interest payments. The weighted-average cost of capital formula solves those problems.

The weighted-average cost of capital is the rate of return that the firm must expect to earn on its average-risk investments in order to provide a fair expected return to all its security holders.We use it to value new assets that have the same risk as the old ones and that support the same ratio of debt. Strictly speaking, the weighted-average cost of capital is an appropriate discount rate only for a project that is a carbon copy of the firm`s existing business. But often it is used as a companywide benchmark discount rate; the benchmark is adjusted upward for unusually risky projects and downward for unusually safe ones.

There is a good musical analogy here. Most of us, lacking perfect pitch, need a well defined reference point, like middle C, before we can sing on key. But anyone who can carry a tune gets relative pitches right. Businesspeople have good intuition about relative risks, at least in industries they are used to, but not about absolute risk or required rates of return. Therefore, they set a company- or industrywide cost of capital as a benchmark. This is not the right hurdle rate for everything the company does, but judgmental adjustments can be made for more risky or less risky ventures.

SOME COMMON MISTAKES

One danger with the weighted-average formula is that it tempts people to make logical errors. Think back to your estimate of the cost of capital for Big Oil: Now you might be tempted to say to yourself, ¬Aha! Big Oil has a good credit rating. It could easily push up its debt ratio to 50 percent. If the interest rate is 9 percent and the required return on equity is 13.5 percent, the weighted-average cost of capital would be

At a discount rate of 9.7 percent, we can justify a lot more investment. ­ That reasoning will get you into trouble. First, if Big Oil increased its borrowing, the lenders would almost certainly demand a higher rate of interest on the debt. Second, as the borrowing increased, the risk of the common stock would also increase and therefore the stockholders would demand a higher return.

There are actually two costs of debt finance. The explicit cost of debt is the rate of interest that bondholders demand. But there is also an implicit cost, because borrowing increases the required return to equity.

When you jumped to the conclusion that Big Oil could lower its weighted-average cost of capital to 9.7 percent by borrowing more, you were recognizing only the explicit cost of debt and not the implicit cost.

The middle line represents average weighted-average costs of capital for a sample of large oil companies. Average costs of equity (for the same sample) and the risk-free rate of interest are also plotted for comparison.