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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 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 m Cash 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 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
comments3
Comments
  • Example: ConcatenatorManufactoring
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