5/24/2020

LEARNING OBJECTIVES
Lecture

6 • Capital structure
• Determining appropriate discount rate for project evaluation
• Introduction of weight average cost of capital (WACC)
COST OF CAPITAL
• Chapter 13, Brealey, Myers & Marcus

Dr. Tien Nguyen

International University - 2020

CAPITAL STRUCTURE

Cost of Capital
• Capital structure - The firm’s mix of long term debt financing and
equity financing. using CAPM
Cost of Capital - The return the firm’s
investors could expect to earn if they
invested in the securities having
comparable degrees of risk.

Cost of Cost of
equity debts
(common Cost of
Cost of (bonds)
stock) equity
(preferred debts (bank
stock) loans)

DETERMINE AAPROPRIATE DISCOUNT USING CAPM FOR PROJECT VALUATION

RATE FOR PROJECT VALUATION

• Suppose McDonalds is considering an expansion of its current

• What return do investors require? operations. The expansion will cost $100 million today and is expected
• Opportunity cost to generate a net cash flow of $25 million per year for the next 20
years.
• CAPM tells us that systematic risk determines required expected
return • What is the appropriate risk-adjusted discount rate for the
expansion project?
• Whose systematic risk?
• What is the NPV of McDonalds’ investment project?
• Project, not company

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MCDONALD’S EXPENTION PROJECT

COMPANY RISK vs. PROJECT RISK

• The risk-adjusted discount rate for the project, rp, can be estimated by • The company-wide discount rate is the appropriate discount rate
using McDonalds’ beta and the CAPM. for evaluating investment projects that have the same risk as the
rP  r f   P [ E (rm )  r f ] firm as a whole.
rP  0.06  0.9(0.07)  12.3% • For investment projects that have different risk from the firm’s
existing assets, the companywide discount rate is not the
• Thus, the NPV of the project is: appropriate discount rate.
• In these cases, we must rely on industry betas for estimates of
20
$25
project risk.
NPV    $100  $83m
t 1 (1.123) t

COMPANY RISK vs. PROJECT RISK COMPANY RISK vs. PROJECT RISK

• Suppose McDonalds is considering investing in the development • The project risk is closer to the risk of other airlines than it is to
of a new airline. the risk of McDonalds’ restaurant business.
• What is the risk of this investment? • The appropriate risk-adjusted discount rate for the project
• What is the appropriate risk-adjusted discount rate for depends upon the risk of the project. If the average beta for
evaluating the project? airlines is 1.1, then the project’s cost of capital is
• Suppose the project offers a 13% p.a. rate of return. Is the
investment a good one for McDonalds? rP  r f   P [ E ( rm )  r f ]
rP  0.06  1.1(0.07)  13.7%

INDUSTRY BETA COMPANY RISK vs. PROJECT RISK

Stock Industry Required

Stock Ticker Industry Return
Beta Beta
America On Line AOL 2.31 Computer Services 1.97
Citigroup C 1.44 Life Insurance 1.26 Project-specific
American Express AXP 1.35 Consumer Financial Services 1.17 Discount rate 13.7%
Microsoft MSFT 1.32 Software and Programming 1.36
AMR (American Airlines) AMR 1.29 Airlines 1.1 Project IRR 13.0%
Intel INTC 1.26 Semiconductors 1.61
IBM IBM 1.23 Computers 1.32 Company-wide 12.3%
General Motors GM 1.11 Auto Manufacturers 1.07 discount rate
Coca-Cola KO 1.07 Non-alcoholic Beverages 1.18
McDonalds MCD 0.89 Restaurants 0.89
EXXON XON 0.59 Oil and Gas 0.56
Reliant Energy REI 0.27 Electric Utilities 0.26
Source: StockQuest, www.marketguide.com Company beta Project beta 

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SUMMARY

Cost of Capital
• The risk of an investment project is given by the project’s beta. using Weight Average Cost of Capital (WACC)
• The Capital Asset Pricing Model provides an estimate of an appropriate
discount rate for the project based upon the project’s beta.
• This discount rate is used when computing the project’s Net Present
Value.

DETERMINING APPROPRIATE DISCOUNT RATE

FOR PROJECT VALUATION WACC

• However, CAPM reflects equity risks, not asset risks
• In company with debts, discount rate should be the weight of cost of
each source of capital by market value
• Step 1: Identify permanent sources of capital
• Step 2: Compute market value and market return for each source
of capital
• Step 3: Weight after-tax cost of each source of capital by market
value

PERMANENT SOURCE OF CAPITAL MARKET VALUE & RETURN FOR DEBT

• Include all classes of equity • Marketable debt

• Include long-term debt • Use current market price to compute yield, or
• Exclude seasonal short-term debt and accounts payable • Compute price using market yield
• Exclude deferred taxes, goodwill • Non-marketable debt
• And other book liabilities that do not generate capital • Estimate current market yield based on
• Credit ratings
• Bank loan rates
• Then compute present value

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MARKET VALUE & RETURN FOR EQUITY VALUE OF THE FIRM

• Marketable equity
• Total value of the assets owned by the firm (V) will be equal to the
• Use current market price for value
sum of
• Use CAPM for expected return
• Market value of debt (D), and
• Or use Gordon model for expected return
• Market value of equity (E)
• Non-marketable equity
• Estimate beta for CAPM using
• Similar companies
• Industry averages
V=D+E
• Then compute present value of projected dividends

AFTER-TAX COST OF CAPITAL WACC

• Interest payments on debt are tax-deductible • Company cost of capital = weight average of debt and equity
• Therefore, cost of debt must be adjusted returns
After - tax cost of debt = pretax cost x (1 - tax rate)
= rdebt x (1 - Tc)
D E
• Dividend payments to shareholders are not tax-deductible WACC  rd (1  TC )  re
V V
• Therefore, no adjustment is necessary for equity

WACC WACC
Example 1: Durian Co. Example 1: Durian Co.

• Market value of Equity

Equity • Debt E=$2.40×15m=$36m
◦P0=$2.40/share • $10 million face value, 8 • Require return (cost of equity)
◦15 million shares years re = 4% + 1.2[12% - 4%] = 13.6%
◦Beta=1.2 • 8% coupon rate
Market value of Debt
◦E(r m)=12% • 6% market yield
 1  (1 . 03 )  16  10 m
• Semi-annual coupons D  400 k    $ 11 . 26 m
◦rf=4%  0 . 03  (1 . 03 ) 16
• Other Require return (cost of debt – before tax)
• Corporate tax rate is 30%  0 . 06 
2

rd  EAR   1    1  6 . 09 %
 2 

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WACC WACC
Example 1: Durian Co. Example 2: Phillips Equipment

• Phillips Equipment has 80,000 bond outstanding that are selling at par
V= D+E = 36m+11.26m =47.26m of $1,000. Bond with similar characteristics are yielding at 6.75%. The
company also has 750,000 shares of 7% $100 preferred stock which is
E D currently sells for $53 a share on the market and 2.5m shares of
WACC  re  rd (1  TC ) common stock outstanding. The common stock has a beta of 1.34
V V
and sells for $42 a share. The US Treasury bill is yielding 2.8% and the
36m 11.26m return on the market is 11.2%. The corporate tax rate is 38%.
 (13.60%)  (6.09%)(1  30%)
47.26m 47.26m  What is the firm’s WACC?
 11.38%

WACC TUTORIALS
Example 2: Phillips Equipment

• Debt
• Market value = 80,000 x 1,000 = $80,000,000 • Textbook, Chapter 13:
• Cost of debt (before tax) = YTM = 6.75%
 2, 4, 6, 8, 14, 11, 22, 24
• Equity (preferred stock)
• Market value = 750,000 x 53 = $39,750,000 • Tutorial handout
• Cost of equity (pref. stock) = (0.07 x 100) / 53 = 0.1321
• Equity (common stock)
• Market value = 2.5m x 42 = $105,000,000
• Re = 0.028 + 1.34(0.112 – 0.028) = 0.14056
• WACC: 80 39.75 105
WACC  0.06751  0.38  0.1321  0.1406
224.75 224.75 224.75
WACC  10.39%