Cameron School of Business UNIVERSITY OF NORTH CAROLINA WILMINGTON. An Introduction to Finance. Edward Graham Professor of Finance Department of Economics and Finance. Continuing your Introduction to Finance. Recalling the Broad Introduction to Finance
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An Introduction to Finance
Professor of Finance
Department of Economics and Finance
Recalling the Broad Introduction to Finance
I. The Three Primary Duties of the Financial Manager
II. The Concept of Risk and Return
III. Capital Structure Choice
Recalling the Dividend Growth Model or DGM, we remember that:
R = D1/Po + g, or our return is comprised of a dividend
yield and a capital gains yield. (p. 292-294)
Or, for a $20 share of Duke Energy expected to pay an
$.80 dividend and sell for $22 in a year, our expected return becomes:
R = .8/20 + .10 = .14
Imagine a game, or choice of games:
Or .02(10 million) + .98 (0) or $200,000
And, 200,000 > 100,000
But, really, do you play Game B?
= (250,000/1m)(.08) + (300,000/1m)(.10) + (.45)(.12) = .104
We achieve a reduction in our portfolio’s variance as in Table 11.7 on page 335 and Figure 11.1 on page 336 with this portfolio.
In an environment with a t-bill or other risk-free asset yielding 3%, our risk premium with this portfolio would be 7.4%.
We avoid, with this portfolio, most of the shock to any one sector or industry (called non-systematic or non-economy-wide risk), but with any risky investment or risky portfolio we still have systematic or economic risk. (As on page 333 of your text in Section 11.3).
With diversification, we get rid of most of the unsystematic or diversifiable risk, but we can only get rid of the economy-wide or non-diversifiable risk with t-bills or certificates of deposit.
WACC = (E/V)Re + (D/V)Rd(1-Tc), with the factors defined.
E is the market value of outstanding equity
V is the market value of the firm, E + D
Re is the required return on equity using the DGM or CAPM
D is the market value of outstanding debt
Rd is the pre-tax cost of borrowing, typically the YTM on the firm’s bonds, or other published borrowing costs
Tc is the marginal tax rate of the firm
An Example (continued)
WACC = (E/V)Re + (D/V)Rd(1-Tc), Tc, the tax rate, is 40%
Suppose a firm has 100 million shares of stock outstanding trading at $50, E is just 50 x 100m or $5 billion.
Assume also the firm has 3 million 8% bonds outstanding trading at $950. They have ten years to maturity, and pay an annual coupon. D is $950 x 3m or $2.85 billion.
V = D + E = $5 billion + $2.85 billion = $7.85 billion
YTM? 1,000 FV, 80 PMT, 10 N, -950 PV, CPT I/Y = 8.77%
Re? Suppose the firm uses the CAPM (the firm could just as easily use the DGM or some other method to estimate its costs of equity), its beta is 1.2, treasury bills are yielding 1%, and the expected market return is 8%.
Re = Rf + Bi(Rm–Rf) = .01 + 1.2(.08 - .01) = .01 + .084 = 9.4%
An Example (continued) WACC = (E/V)Re + (D/V)Rd(1-Tc)
E = $5b, D = $2.85b, V = $7.85b
E/V = the equity weight = (5/7.85) = .637,
D/V = the debt weight = (2.85/7.85) = 1 - .637 = .363
Rd = YTM = I/Y = 8.77% = .0877
Re = 9.4% (from the CAPM) = .094
Tc is still 40% or .4
WACC = (.637).094 + (.363).0877(.6) = .06 + .019 = 7.9%
What does this 7.9% WACC actually mean? It is the suggested discount rate (NPV) or hurdle rate (IRR) that the firm should use with “typical” projects of average risk for the firm. The WACC has clear theoretical extensions to such theories as the static tradeoff theory or the pecking order theory of capital structure.