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FINE 3010-01 Financial Management

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FINE 3010-01 Financial Management

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FINE 3010-01Financial Management

Instructor: RogérioMazali

Lecture 14: 12/05/2011

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

- 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

- 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!

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

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

100,000 / 1.102

- 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?

- 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%.

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

- We can now state our tax-included WACC formula:
- In our Geothermal Example, we have:

- 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?

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

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

- Another Example:

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%

TV5 = 2.5 / (0.1075 – 0.03)

- 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:

- 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.

- Required Rates of Return:
- Bonds: rdebt = YTM;
- Common Stock:
- CAPM:
- DDM:

- Preferred Stock:
- Fixed dividend:

- Bank Loans: Interest on Bank Loan

- 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

- 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: ConcatenatorManufactoring