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The Weighted Average Cost of Capital and Company Valuation

The Weighted Average Cost of Capital and Company Valuation. Chapter 13 Fundamentals of Corporate Finance 2012 Linköpings universitet. Ivar Kreugers (1880-1932) Tändsticks imperium: debt can be bad. 1917 bildades Finanskoncernen Kreuger & Toll

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The Weighted Average Cost of Capital and Company Valuation

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  1. The Weighted Average Cost of Capital and Company Valuation Chapter 13 Fundamentals of Corporate Finance2012Linköpings universitet

  2. Ivar Kreugers (1880-1932) Tändsticks imperium: debtcan be bad. • 1917 bildades Finanskoncernen Kreuger & Toll • Svenska Tändsticks AB, 1930 omfattade 60 % av världens tändsticksproduktion. • Kreuger & Toll Pris föll från sin högsta notering i mars 1929 på över 46 dollar till 4,5 dollar i slutet av 1931 • 1929 depression, och han fick likviditetskris • Dock hans imperium blev grunden för många svenska koncernen. Ivar Kreuger omkring 1930 vid sitt skrivbord i Tändstickspalatset

  3. Topics • Cost of Capital • Weighted Average Cost of Capital (WACC) • Measuring Capital Structure • Calculating Required Rates of Return • Calculating WACC • Interpreting WACC • Valuing Entire Businesses

  4. Concept: Cost of Capital Most companies are financed by a mixture of securities. Including common stock, bonds, and other securities. These securities have different risks, therefore investors require different return on them. Cost of Capital – required rate of return on investment. It is the return the firm’s investors could expect to earn if they invested in other equally risky securities.

  5. Capital Structure Capital Structure - The firm’s mix of debt financing and equity financing. Long term capital structure involves only long term debt and equity Market value of debt and market value of equity corresponds to the market capital structure. This is to differentiate from the book value of debt and equity.

  6. WACC • Taxes are an important consideration in the company cost of capital, because interest payments are tax deductible.

  7. WACC Weighted Average Cost of Capital (WACC) The expected rate of return on a portfolio of all the firm’s securities, adjusted for tax savings due to interest payments. Company cost of capital = Weighted average of debt and equity returns.

  8. WACC Weighted Average Cost of Capital = WACC

  9. WACC Three Steps to Calculating Cost of Capital 1. Calculate the proportion of firm´s debt and equity. 2. Determine the required rate of return on equity and debt. 3. Calculate a weighted average after tax return on the debt and equity.

  10. Cost of Capital Example - Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital?

  11. Cost of Capital Example - Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital?

  12. Cost of Capital Example - Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital? Interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2% (i.e. 8 % x .65).

  13. WACC

  14. WACC Weighted Average Cost of Capital with debt, equity and Preferred Stock Preferred stock provides a specific dividend that is paid before any dividends are paid to common stock. Where D is the value of debt, E is the value of equity, P is preferred stock, τ is tax rate.

  15. WACC Example - Executive Fruit has issued debt, preferred stock and common stock. The market value of these securities are $4mil, $2mil, and $6mil, respectively. The required returns are 6%, 12%, and 18%, respectively. Q: Determine the WACC for Executive Fruit, Inc.

  16. WACC Example - continued Step 1 Firm Value = 4 + 2 + 6 = $12 mil Step 2 Required returns are given Step 3

  17. Measuring Market Capital Structure Market Value of Bonds – Present Value of all coupons and par value discounted at the current yield to maturity, YTM. Market Value of Equity - Market price per share multiplied by the number of outstanding shares.

  18. Measuring Market Capital Structure Page 374/5 Example: Suppose Long term bond has a coupon payment of 8%, 12 year to maturity. Common stocks 100 million shares valued at 12 $ each

  19. Measuring Market Capital Structure If the long term bonds pay an 8% coupon and mature in 12 years, market interest rate is 9%, what is the market value of the bonds?

  20. Measuring Capital Structure

  21. On Common Stock Cost of capital is the same as the Required Rates of Return On Bonds That is, expected return on stock is equal to risk free return plus beta times market risk premium.

  22. Required Rates of Return can also be obtained from DDM Dividend Discount Model (DDM) Constant Dividend Growth Model = solve for re

  23. Required Rates of Return Expected Return on Preferred Stock Price of Preferred Stock = solve for preferred

  24. WACC for Selected Firms

  25. Interpreting WACC • The WACC is an appropriate discount rate only for a project that is the same 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 increased required return from equity due to increased bankruptcy probability.

  26. WACC Issues in Using WACC Debt has two costs. 1)return on debt and 2)increased cost of equity demanded due to the increase in risk of bankruptcy • Betas may change with capital structure • Corporate taxes complicate the analysis and may change our decision

  27. FCF and PV • Free Cash flow is cash flow that is available to investors, FCF= operating cash flow - investment expenditures. • FCF is a more accurate measurement of PV than either Dividend or Earnings per share EPS. • Free Cash Flows (FCF) should be the theoretical basis for all PV calculations. • When valuing a business for purchase, always use FCF.

  28. Capital Budgeting • Valuing a Business • The value of a business or project is usually computed as the discounted value of FCF out to a valuation horizon (H). • The valuation horizon is sometimes called the terminal value and is calculated like present value of growth opportunity (PVGO).

  29. Capital Budgeting • Valuing a Business or Project PV (free cash flows) PV (horizon value)

  30. Capital Budgeting See P 382/3, Example - ConcatenatorManufacturing, cash flows are provided as follows: y1=-73,6 y2=-87,1 y3=-102,9 Y4=-34,1 y5=40,2 y6=79,5 with a discount rate 8,5%, and a steady growth of 5% from year 5 onwards.

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