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# 45-822 - Corporate Finance

## 45-822 Corporate Finance Mini 2 2017

Carnegie Mellon University
Brent Glover

## :: Have one member email me with the group members and a

rank ordering of your case preferences
:: See the List of Cases page on Canvas

Why WACC?

## Nike Cost of Capital Case Discussion 3

What is WACC?

D E
rWACC = (1 )rD + rE
D +E D +E

## I What do rD and rE represent here?

I Why are we multiplying rD by (1 )?
I Didnt we already count taxes in the FCF calculation?

## Nike Cost of Capital Case Discussion 4

Joannas Single Cost of Capital

## Joanna decides to compute a single cost of capital for the

company.
different enough risks from each other to warrant different
costs of capital.
I Since I believe they face the same risk factors, I decided to
compute only one cost of capital for the whole company.

capital?

## Nike Cost of Capital Case Discussion 5

Joannas WACC

Were there any problems with how Joanna computed the WACC?
D E
rWACC = (1 )rD + rE
D +E D +E

## Three inputs to discuss:

D
I Leverage ratio: D+E
I Required return on debt: rD
I Required return on equity: rE

## Nike Cost of Capital Case Discussion 6

Inputs: Leverage Ratio, D and E weights

Debt:

Equity

Inputs: rD

Inputs: rE

## Nike Cost of Capital Case Discussion 9

Estimating rE using CAPM

rE using CAPM:
rE = rf + E E(rm rf )

## Nike Cost of Capital Case Discussion 10

Estimating rE using Dividend Discount Model

d1
rEDDM = +g
P0

## :: Equity holders are claimants to the perpetual stream of

dividends. What would you pay for Nikes equity?

## :: The PV of the stream of future dividends. If we assume

current price reflects this and make an assumption about the
future growth rate of dividends, we can back out rE :
d1
P0 = DDM
rE g

## :: What are we assuming here?

:: Anything wrong with the value we get for rEDDM ?
Nike Cost of Capital Case Discussion 11
rE using DDM

## Nike Cost of Capital Case Discussion 12

Unlevering and WACC Recap

Levered Firm

## Think of the levered firm as the sum of an identical unlevered firm,

plus the value of the tax shields on debt:

Debt
VU
=

Equity
PV (Tax Shields)

X FCFt
+ PV(Interest Tax Shields) = Debt + Equity
t=1
(1 + rU )t
Nike Cost of Capital Case Discussion 14
Valuing Tax Shields

X FCFt
VL = + PV(Interest Tax Shields)
(1 + rU )t
t=1

When interest is tax deductible, the firm is paying less cash flow in
taxes to the government
:: More left for the security holders: debt and equity

explicitly here:
X E (ITSt )
PV (ITS) =
t
(1 + rTS )t

Unlevering

## I When we estimate a using a companys stock returns,

which are we measuring?

## I Often, we want to compute r , . How do we do this?

I Estimate values for D/V , rD , and rE

obtain r or

## I Simplest unlevering formula: assume unlevered return is equal

to return on assets (opportunity cost of capital)

D E
r rA = rD + rE
V V

Unlevering

## I Unlevering E or rE to get or r requires assumptions

about the risk of the tax shields

## I Different assumptions result in different unlevering formulas

I And different formulas relating WACC r to unlevered cost of
capital r

## I The differences in these unlevering formulas are quantitatively

small unless leverage is very high
I Important to understand why different formulas appear
I In practice, can look up the appropriate formula to apply

## Nike Cost of Capital Case Discussion 17

Unlevered vs. Average

The firms assets include the tax shields, which are low risk.
D E
rA = rD + rE = (1 w )r + wrTS
V V
and,
D E
A = D + E = (1 w ) + w TS
V V
where
PV(TS)
w= .
V

## r , answer: What would the firms cost of capital, or beta, be

if it were unlevered?

## Nike Cost of Capital Case Discussion 18

Unlevering Betas

D E
A = D + E = (1 w ) + w TS
V V
where
PV(TS)
w= .
V
Analyst can:
I Estimate E and D from returns on the firms securities, or
similar financial assets.
I Using debt-to-value ratio can then calculate A

## To estimate the unlevered , and use it to estimate the all-equity

cost of capital, r , need to make assumptions about risk of the tax
shields.

## Nike Cost of Capital Case Discussion 19

Continuous Rebalancing (rTS = r )

## With continuous rebalancing of capital structure firm maintains a

constant debt-value ratio.
I w constant through time
I TS = because the tax shields change with the firms value.
I In this case
PV (TS) VU
A = TS + =
VL VL
I This justifies naively unlevering the beta: = A .

## (Note this ignores bankruptcy costs):

VL = VU + PV (TS) = D + E

## Nike Cost of Capital Case Discussion 20

D
a. Estimating the proportion of debt D+E

## I Use market (not book) values

I Use net debt (Debt - Cash)

## I Market value of equity: #shares share price

I Want market value of debt, but often hard to calculate. Can
use book debt as a proxy if the value was recorded when:
i) interest rates were similar to today, and
ii) the firms credit rating was similar.
I Otherwise, take current rD and discount the remaining
expected debt payments with it

## Nike Cost of Capital Case Discussion 21

How do we decide what is debt or not?

## I Cash: All necessary cash is an operating asset. All excess

cash reduces the net debt measure
I Accounts Payable: If an integral part of doing business,
should be counted as a negative operating asset and offset
against accounts receivable (in WC).
If main purpose is financial, then its (often very expensive)
debt.
I Other Liabilities: borrowing from the pension fund, hybrid
securities,. . . They are debt if
i. they are senior to equity, and

b. Estimating rD

## 1. Observing the price of outstanding bonds

- Often the promised yield is used as the cost of debt

## 2. Observing the credit rating

- Use the average yield corresponding to the credit rating

## 3. Making your own rating

- Use financial ratios to infer a rating and/or a credit spread

## :: Recall: yield on a risky (defaultable) bond is not the same as

the expected return. But for low default probability/high
recovery rate (investment grade bonds) the yield is close to rD
Nike Cost of Capital Case Discussion 23
Estimating rE

## CAPM for firm i:

rE ,i = rf + E ,i E(rm rf )

## :: ri,t return on stock i for period t

:: rf ,t risk-free return for period t
:: rm,t risk-free return for period t
:: i : intercept (=0 according to the CAPM)
:: i : equity beta for stock i

Back to Snap

## Nike is an older, mature firm, compared to Snap. Relative to Snap,

does that mean Nike should have:

## Nike Cost of Capital Case Discussion 25

Estimating Snaps cost of capital

1. Pick comparables
2. Estimate comparable E s
3. Unlever E s
4. Average across these
5. Lever up to company of interest (Snap) capital structure
6. Compute WACC

:: E=10.29, D = 1.69, Cash = 3.78

:: E= 402.7, D= 0, Cash = 29.45

estimates

TWTR -.021 1.34
(0.027) (0.859)

FB .023 0.75
(0.017) (0.548)

Snap?)