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FINE 3010-01 Financial Management. Instructor: Rogério Mazali Lecture 14: 12/05/2011. FINE 3010-04 Instructor: Rogério Mazali. Fundamentals of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Alan J. Marcus McGraw Hill/Irwin. Chapter 13:

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Fine 3010 01 financial management

FINE 3010-01Financial Management

Instructor: RogérioMazali

Lecture 14: 12/05/2011


Fine 3010 04 instructor rog rio mazali

FINE 3010-04Instructor: RogérioMazali

Fundamentals of Corporate Finance

Sixth Edition

Richard A. Brealey

Stewart C. Myers

Alan J. Marcus

McGraw Hill/Irwin

Chapter 13:

The Weighted-Average Cost of Capital and Company Valuation


Agenda

Agenda

  • Cost of Capital of an All-Equity Firms

  • Cost of Capital of Leveraged Firms: the Weighted- Average Cost of Capital (WACC)

    • Use Market Weights, not Book Weights

    • Taxes and the WACC

    • Three (or more) Sources of Funding

  • Measuring Capital Structure

    • Expected Rates of Return on Bonds

    • Expected Return on Common Stock

    • Expected Return on Preferred Stock

  • Valuing Entire Businesses


Cost of capital of all equity firms

Cost of Capital of All-Equity Firms

  • According to the CAPM, the expected return of any security i is given by:

    E(Ri) = rf + βi * [E(RM) – rf]

    where βi= Cov(Ri, RM) / Var(RM).

    That is, if the firm is 100% equity financed, we can discount the cash flows of security i at this rate!


Cost of capital of all equity firms1

Cost of Capital of All-Equity Firms

An all-equity firm is considering an investment opportunity with these features:

Initial Investment:350,000

Cash Flows (5 years):100,000

Risk-free Rate: 3%

E(RM): 9%

Beta of our firm is 1.2 AND the project has the same risk as the firm


Cost of capital of all equity firms2

Cost of Capital of All-Equity Firms

Step 1: Calculate the Cost of Equity Capital

E(R) = rf + β [E(RM) – rf ]= 0.03 + 1.2 * [0.09 – 0.03] = 0.102

Step 2: Calculate the NPV of the project


Cost of capital of all equity firms3

Cost of Capital of All-Equity Firms

100,000 / 1.102


Cost of capital of leveraged firms the weighted average cost of capital wacc

Cost of Capital of Leveraged Firms: the Weighted- Average Cost of Capital (WACC)

  • Consider now a firm that has been financed by both debt and equity:

    • Bondholders expect return rdebt on their investment

    • Shareholders expect return requity on their investment

  • Q: How much return should a project give in order to be considered viable?

  • A: Enough money to pay both shareholders and bondholders

  • Q: And how much is that, exactly?


Cost of capital of leveraged firms the weighted average cost of capital wacc1

Cost of Capital of Leveraged Firms: the Weighted- Average Cost of Capital (WACC)

  • Consider the following example: Geothermal Corp.

  • Company debt pays return rdebt = 8%.

  • Company stock pays return requity = 14%.

  • Therefore, shareholders require extra requity × E = 0.14 × $453 mi = $63.42 mi.

  • Also, bondholders require extra rdebt × D = 0.08 × $194 mi = $15.52 mi.

  • Newly created assets would be then = $63.42 mi + $15.52 mi = $78.94 mi, and ROA = $78.94/$647 = .122 = 12.2%.


Cost of capital of leveraged firms the weighted average cost of capital wacc2

Cost of Capital of Leveraged Firms: the Weighted- Average Cost of Capital (WACC)

  • This procedure is known as the Weighted Average Cost of Capital (WACC).


Taxes and the wacc

Taxes and the WACC

  • So far we have not considered the effect of taxes on the cost of capital.

  • Why are taxes important?

  • Note that interest payments are tax-deductible:

    • For each $1 paid in interest, taxable income is reduced by $1, and the firm’s tax bill is reduced by $0.35 (if the firm is in the 35% tax rate bracket).


Taxes and the wacc1

Taxes and the WACC

  • We can now state our tax-included WACC formula:

  • In our Geothermal Example, we have:


Valuing an entire business

Valuing an Entire Business

  • Example:

    I0 = 50 mCash Flows (for 6 years) = 12 m each year

    Debt/Equity ratio: 0.6

    Cost of Debt:15.15%

    Cost of Equity:20%

    Tax Rate:34%

    Is this a good project?


Valuing an entire business1

Valuing an Entire Business

Step 1: Calculate the Cost of Equity Capital

Step 2: Calculate the Cost of Debt

Step 3: Calculate the WACC

Step 4: Calculate the PV & the NPV of the project


Valuing an entire business2

Valuing an Entire Business

Step 1: Calculate the Cost of Equity Capital

E(RE) = 0.20

Step 2: Calculate the Cost of Debt

E(RD) = 0.1515

Step 3: Calculate WACC

Additional input: Debt/Value = 0.6 /(0.6 + 1) = 0.375

Equity/Value = 1- 0.375 = 0.625

WACC = 0.375 * 0.1515 * (1 – 0.34) + 0.625 * 0.2 = 0.1625

Step 4: Calculate the NPV of the project


Valuing an entire business3

Valuing an Entire Business


Valuing an entire business4

Valuing an Entire Business

  • Another Example:


Valuing an entire business5

Valuing an Entire Business

Market Value of Debt: 60 * 120 % = 72

Market Value of Equity:5 * 20 = 100

Debt / (Debt + Equity) = 72 / 172 = 41.9 %

Equity / (Debt + Equity)= 100 / 172 = 58.1 %

Cost of Equity: 0.03 + 1.4 [0.1 – 0.03] = 0.128

Cost of Debt:0.12 (equal to YTM)

WACC = 0.419 * 0.12 * 0.66 + 0.581 * 0.128 = 10.75%


Valuing an entire business6

Valuing an Entire Business

TV5 = 2.5 / (0.1075 – 0.03)


Three or more sources of funding

Three (or more) Sources of Funding

  • Consider the case in which the firm is funded by:

    • Debt

    • Common stock

    • Preferred stock

  • WACC formula can be adapted to include all 3 sources of funding:

  • In general, if Vn is the amount of the firm’s assets financed by means n, then:


Comments

Comments

  • When calculating capital structure, use market values, not book values.

Market Value of Bonds - PV of all coupons and par value discounted at the current YTM.

Market Value of Equity - Market price per share multiplied by the number of outstanding shares.


Comments1

Comments

  • Required Rates of Return:

    • Bonds: rdebt = YTM;

    • Common Stock:

      • CAPM:

      • DDM:

    • Preferred Stock:

      • Fixed dividend:

    • Bank Loans: Interest on Bank Loan


Comments2

Comments

  • The WACC is an appropriate discount rate only for a project that is a carbon copy of the firm's existing business

  • There are two costs of debt financing. The explicit cost of debt is the rate of interest bondholders demand. The implicit cost is the required increase in return from equity.

  • When evaluating a business, always use Free Cash Flows (FCF)

    • FCF = Op. CF – Inv. In PPE and working capital


Example concatenator manufacturing

Example: Concatenator Manufacturing

  • Capital Structure: 60% Equity, 40% Debt

  • Cost of debt: 5%

  • Cost of equity: 12%

  • Growth after horizon period: 5%

  • Cash Flows: See Next Table


Example concatenator manufacturing1

Example: Concatenator Manufacturing


Comments3

Comments

  • Example: ConcatenatorManufactoring


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