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Fifth Edition
Chapter 12
The Weighted-Average Cost of Capital and Company Valuation
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Topics Covered
Geothermals Cost of Capital Weighted Average Cost of Capital (WACC) Measuring Capital Structure Calculating Required Rates of Return Calculating WACC Interpreting WACC Valuing Entire Businesses
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Cost of Capital
Cost of Capital - The return the firms investors could expect to earn if they invested in securities with comparable degrees of risk. Capital Structure - The firms mix of long term financing and equity financing.
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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?
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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?
Market Value Debt $4441% 1 Market Value Equity $4441% 1 Market Value Assets $1111% 11
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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?
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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? Portfolio Return = (.11 + (.111 = 1.1 x %) x %) 1%
Interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2% (i.e. 8 % x .65).
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WACC
Weighted Average Cost of Capital (WACC) - The expected rate of return on a portfolio of all the firms securities.
Company cost of capital = Weighted average of debt and equity returns.
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WACC
rassets =
rassets =
D V
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WACC
Taxes are an important consideration in the company cost of capital because interest payments are deducted from income before tax is calculated.
After - tax cost o f debt = pretax cos t x (1- tax rate) = rdebt x (1- Tc)
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WACC
Weighted -average cost of capital=
WACC =
D V
x (1- Tc)rdebt +
] [
E V
x requity
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WACC
Three Steps to Calculating Cost of Capital 1. Calculate the value of each security as a proportion of the firms market value. 2. Determine the required rate of return on each security. 3. Calculate a weighted average of these required returns.
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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.
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WACC
Example - continued Step 1 Firm Value = 4 + 2 + 6 = $12 mil Step 2 Required returns are given Step 3
WACC =
1 1 1
x(111 1 + -. ).1
] (
1 1 1
x.44 +
) (
1 1 1
x.44
=.1111.1 or 1 %
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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 E Bassets change withBdebt + V x Bequity = D x capital structure V Betas may
] [
Corporate taxes complicate the analysis and may change our decision
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If the long term bonds pay an 8% coupon and mature in 12 years, what is their market value assuming a 9% YTM?
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Big Oil MARKET Value Balance Sheet (mil) Bank Debt (mil) $ 11 1 .1 1 .1 1% LT Bonds $ 44 4 .4 1 .1 1% Total Debt $ 11 1 .1 4 .4 4% Common Stock $ 1 1 .1 ,1 1 1 .1 1% Total $ 1 1 .1 1 1 % ,1 1 1 .1
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rd = YTM
Common Stock
re = CAPM = rf + B(rm - rf )
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Div1 P1 = re - g
solve for re Div1 re = + g P1
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P1 =
solve for preferred
Div1 rpreferred
rpreferred
Div1 = P1
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* FCF and PV *
Free Cash Flows (FCF) should be the theoretical basis for all PV calculations. FCF is a more accurate measurement of PV than either Div or EPS. The market price does not always reflect the PV of FCF. When valuing a business for purchase, always use FCF.
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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 PVGO.
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Capital Budgeting
Valuing a Business or Project
FCF1 FCF1 FCFH PVH PV = + + ... + + 1 1 H (1 r ) (1 r ) + + (1 r ) + (1 r ) H +
PV (free cash flows) PV (horizon value)
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Capital Budgeting
Example - Concatenator Manufacturing
.
= 1 1.1 ,11 1
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