MBA 643 Managerial Finance Lecture 9: Weighted Average Cost of Capital

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MBA 643 Managerial Finance Lecture 9: Weighted Average Cost of Capital. Spring 2006 Jim Hsieh. Introduction. From the NPV rule, we accept the project when its NPV&gt;0: But how do we get “r”?

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### MBA 643Managerial FinanceLecture 9: Weighted Average Cost of Capital

Spring 2006

Jim Hsieh

Introduction
• From the NPV rule, we accept the project when its NPV>0:
• But how do we get “r”?
• Cost of Capital: The return the firm’s investors could expect to earn if they invested in securities with comparable risk.
• Firms have different types of investors.
Components of Cost of Capital
• Capital Structure: The firm’s mix of long-term debt financing (D) and equity financing (E).
• Balance Sheet Model (Market Value): A = D + E: It represents the claims for debtholders and stockholders.
• Various Components of Cost of Capital:
• Cost of Debt (rD)
• Cost of Preferred Stock (rpreferred)
• Cost of Common Stock (rE)
• Usually we put cost of preferred stock with cost of debt.
Weighted Average Cost of Capital
• Question: If a firm has both debt and equity capital, how can we determine its overall cost of capital?
• Answer: A firm’s overall cost of capital should reflect the required rate of return on the firm’s assets as a whole.
• It is a mixture of the returns required to compensate its creditors and stockholders.
• Definition: The weighted average cost of capital (WACC) is the expected rate of return on a portfolio of all firm’s securities.
• Company overall cost of capital = weighted average of debt and equity returns
Estimating WACC -- from A = D + E
• Case 1: If the firm pays no tax,

rA = WACC = (Total dollar return)/(Initial investments)

= (D*rD + E*rE)/V

= (D/V)*rD + (E/V)*rE = wDrD + wErE

• Case 2: If the firm pays tax,
• Interest payments are deducted from income before tax is calculated.
• After-tax cost of debt = (pre-tax cost of debt)*(1-tax rate)

=rD(1-TC) where TC = corporate marginal tax rate

WACC = (D/V)*rD*(1-TC) + (E/V)*rE = wDrD(1-TC) + wErE

Example 1
• FinPro Inc. has issued debt and common stock. The market values of these securities are \$5mm and \$8mm, respectively. Given that the company pays 7% for debt and 12% for equity, what is the WACC for FinPro? The company has a marginal tax rate equal to 40%.

WACC = wD*rD*(1-TC) + wE*rE

= (5/13)*0.07*(1-0.4)+(8/13)*0.12 = 0.09

Estimating rD, rE, and rpreferred (recap)
• Cost of debt = rD = YTM*(1-TC)
• Cost of preferred stock:
• Since we know P0 = Div1/r for preferred stock, rpreferred = Div1/P0
• Cost of equity:
• Approach 1: From SML: rE = rf + (rm – rf)
• Approach 2: From DDM: P0 = Div1/(rE - g) => rE = Div1/P0 + g