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The Short Story of WACC

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The Short Story of WACC
What Costs are Measured?

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G ebt Costs:
 Bank loans
 Long
Long--term debt G bonds/debentures
G uity Costs:
 Preferred euity costs
 Common euity costs

c  c
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The Short Story of WACC
Why the Marginal Cost?

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c  c
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The Short Story of WACC
Steps in Solving for the WACC

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The Cost of Capital
etermining the Weighted Average Cost of Capital (WACC)

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S P D
WACC Ke ´ K p ´ K d ( -T) pppppp
â V V V

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The Short Story of WACC

## (1) (2) (3) (4) = (2)*(3)

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' (
c

o -Ter De t 5.5% 43.0% 0.02365
referred Stoc 11.4% 11.0% 0.01254
Co o Stoc 12.9% 46.0% 0.05934
'cc) * +

## WACC is the su of the wei hted

specific ar i al costs of each source of
capital.

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Market Values!

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stimating Market Values
Market Value of Bonds

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 

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Costs of isting Capital

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Cost of uity
Constant Growth Model Caution

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G This usually means, using it only for large, mature µblue-
µblue-chip¶
companies that already pay a significant dividend

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Alternate Model for the Cost of uity
Using the CAPM to estimate Ke

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#
G The RF (risk-
(risk-free) rate is the benchmark return and is measured
directly, today as the yield on -day T T--bills
G The market risk premium (MRP) is taken from current market
estimates of the overall return in the market, less RF (RM GRF)
G Using this model reuires us to think about the inputs however
as they can have a significant impact on project evaluation

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Risk--Based Models & the Cost of uity
Risk
Using the CAPM to estimate the cost of common euity

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â Ke F ´ P  4 e pp

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K * investor¶s reuired rate of return
* the stock¶s beta coefficient
Y * the risk-
risk-free rate of return
Y * the market risk premium (RM - Rf )

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Risk--Based Models & the Cost of uity
Risk

â Ke F ´ P  4 e pp

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estimate of the RM
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Risk--Based Models & the Cost of uity
Risk
Using the CAPM to stimate the Cost of Common uity

 . -
   /0 1c 2
 3 Investors are
It would
unlikely be
to epect

better
negativetoreturns
use
average
on the stock
market If they
7 7 realized
did, no one would
- 7 returns over
hold shares!
- 8 an entire
Who would have
7
guessed before
8
ketthere
hand, cycle would
be two
7
consecutive years
of aggregate
market losses?

## Such is the reality

of investing since
none of us are
clairvoyant
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Risk--Based Models & the Cost of uity
Risk
Using the CAPM to stimate the Cost of Common uity

##  - 4  !4

!  & !
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5-   6

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4 5 6  !5 6 !!& 
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5 6

## o e nment of Canada easu y Bills 5 20 5 11 4 32

o e nment of Canada Bonds 6 62 6 24 9 32
Canadian to ks 11 9 10 60 16 22
U to ks 13 15 11 6 1 54

## ou e: ata f om Canadian Institute of A tua ies

he isk
A e age onsensus
that the Canadian MRP o e the long-te m
sto ks oyield
bond e bonds
(anwas
obse 5 1 able yield) is between 4 0 and 5 5

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Risk--Based Models & the Cost of uity
Risk
stimating Betas

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Risk--Based Models & the Cost of uity
Risk
stimated Betas for Sub Indees of the S&P/TSX Composite Inde

  9 :

c  c
 c    -,
Risk--Based Models & the Cost of uity
Risk
stimated Betas for Sub Indees of the S&P/TSX Composite Inde

j = 
#
G IT sub inde shows rapidly increasing betas
G ther sub inde betas show constant or decreasing trends

j 
 #
G The weighted average of all betas * (by definition they are
the market)
G If one sub inde is changing«that change alone affects all
others in the opposite direction

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 
 BB\$6
?

 
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
F
G The internet bubble of the late s resulted in rapid growth in
the IT sector till it burst in the early s

c  c
 c    -
Risk--Based Models & the Cost of uity
Risk
stimating Betas

IT
Bubble
-   
 


   

 
c

c
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-
-
- -
- -
-

our e Data from 4     pp rpra epna erpDa aba e

c  c
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Risk--Based Models & the Cost of uity
Risk
Adjusting Beta stimates and stablishing a Range

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
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
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j ,
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   

   

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
G Using current MRP and Y evelop estimates of Ke
using the range of Company betas prior to the bubble
or crash

c  c
 c    -
Costs of isting Capital

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' 54<)3

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 c    
Cost of uity Capital

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j ?&2&27G
G Recall that the cost of euity capital is an estimate
which tries to approimate what shareholders reuire
as a return compensating them for the risks they face

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
  
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
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c  c
 c    
stimating the Component Costs
Floatation Costs

## j &  

 
  

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

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
j 
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#
G Underwriting discounts paid to the investment dealer
G irect costs associated with the issue including legal and
accounting costs
j 

#
G et proceeds on the sale of each security is less than what the
investor invests, and
G The component cost of capital > investor¶s reuired return

  !"#
!"#   \$   \$  %     
&

c  c
 c    
stimating the Component Costs
Floatation Costs and the Marginal Cost of Capital (MCC)

9  

 
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     

 c

 ;
 
 

     
 ;   
Commer ial paper . 
    


Medi m-term notes .   < 
ong-term de t .  ;  

  

 
  
 it (large) . 

    <  
 it (small) . - . 


 

   
 it (pri ate) . and p       
 
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  

 

What isse osts mean is that there is a finan ing wedge etween what the
in estor pa s and what the firm re ei es, the differen e eing the mone
that is lost to these osts. Isse osts are responsi le for the omponent
ost of apital eing greater than the in estor¶s reqired retrn.

c  c
 c    
Floatation Cost Calculation

j 


 
   #
G  Floatation Method
G et Proceeds Method

j 
C 


 



 

  

 ' .. C)



 

  

 '
 
   


G K new * K / ( -fl)

j 
@
4




 
 

H
I 


(  
 
 



 

c  c
 c    
Floatation Cost Calculation

j 

 



%
 


 
( 



 
  
  C

j 2 

  
 


 
 ,
  



 
 
C

 


( 







G  Float estimates are  \$' lower than et Proceeds
estimates for Ke
G If precision is SSTIAL, use the net proceeds method (its not
in this course so  float method is fine to use in all cases)
c  c
 c    
The Component Cost of ebt

## j & ,  



"
(

 
  


%
 
 



 



 
 
  
#
The after ta cost of
debt is lower than the
j !
# investor¶s reuired
K% *  (debt investor¶s reuired return) return because of the
 *  (corporate ta rate) ta shield on interest
epense
% *  (floatation cost percentage)

##  p  p p


pp p p pp
  
 
   
ppppppppppppppppppppp  
  

c  c
 c    ,
stimating the Component Costs
ebt

j !
 
 
    

%..
  


%

 





%
 


 


  '
 
) 


'
) 


'  )




 
(#
Coupon interest times minus corporate
ta rate * after ta cost of interest

 
 ( ´ ) = 
â- N I
  =ew
´ =
pppppp
 =ew  ( ´ =ew )
 

## et proceeds on the sale of the bond * Selling price G

floatation cost per bond
j  




..% 

% 
.. 

c  c
 c    
stimating the Component Costs
Preferred Shares

Floatation
j &,  




 costs cause

"
(

 the component

   
  cost to be
greater than






 the investor¶s

     reuired






 return

 
  
#

##   p  p 

j !
# pp  p p pp
  
Kp *  (preferred investor¶s
 
reuired return) pppppppppppppppppppp p 
  
F *  (floatation cost percentage)

## T: Preferred dividends are paid out of after-

ta earnings, therefore there are no taation effects
on the preferred share component cost of capital
c  c
 c    
stimating the Component Costs
Preferred Shares

j !
 







 
  
( *<.. / 



 
  
( *<
@4

 








 



p
â-  =ew  ppppp
N

c  c
 c    -
Constant Growth Model
The Cost of ew uity

j 

 






(  @4'












 )


â-  =ew  ´ °ppppp
N

c  c
 c    
Risk--Based Models and the Cost of Common
Risk
uity
Using CAPM to stimate Kne

j
 




(
"

(

  

 

( 
   

KE
â K E=e

  fle

c  c
 c    
A note of new vs eisting capital

## j :@+@7&:92 !@+2 !@+2 


 


% 

% 




  

G
G There is no such thing as K or KP ecept when using
it to calculate K new and KPnew
G Money raised from these sources but not spent end
up as common euity

j 7   


%  
( 


+ 
 




 


 +

G (
    

c  c
 c    
WACC versus MCC
Floatation Costs and the Marginal Cost of Capital (MCC)

j 
9 '9)







%   



j ! 

   
 ! 9
j !

 
 


 
%



 


 



G Therefore MCC increases with the amount of capital
to be raised

c  c
 c    
   ) \$ \$     
&
The Marginal Cost of Capital MCC

S 

   e ´  =ew
  S 
   (   =ew ´  =ew
 
  
  erepp=lyp=ep reakp=p ep prve.pIp
 ( ´ )
   
  rpap

.pp p pp=p epfrmp ap   ´ )
 
 
 (
 ´ 
 ex aedpp=er=alpeqypa=ppraepmrep
 
 ´ 

eqypapalpwllpmea=pae=°pexer=alp
 ( ´ ((  
eqyp=°p epervepfpa=p=erwrer.  ) ´ ((  

\$""(%p 
V \$"" %&'""%p
ach dollar of capital invested up to ach dollar of capital invested
\$ million is financed V by beyond \$ million is financed
internal euity (R/) ( V × cost V by new euity ( V ×
cost of new euity * )
of retained earnings * ?)
? ?
ach dollar of capital invested is financed V by debt (V × after-ta cost * ? ?)

## V \$ ,VVV,VVV \$ ,VVV,VVV \$ ,VVV,VVV \$ ,VVV,VVV \$ V,VVV,VVV

p!p"pp# p  

c  c
 c    
Investment pportunity Schedule
A etailed ample «

j ! 

 

J



 &



j  

;

 # 
 b


m 
d h
 b

h 
c     c 
 
g v
\$

  c 

 
 
    ! "## #\$ %
 &   ' & && \$'%
c &!  ( ' &(& ( &\$!%
) # ( ! (!&! \$(%
*  # &#(  ! #\$%
 ( ( #  ('! \$%

c  c
 c    
Investment pportunity Schedule
A etailed ample «

## The first step in developing an IS is to order the projects

from highest IRR to lowest, and then to calculate the
cumulative capital cost of the projects

c   c   c

 =   c
  =

 9 5,000 9 5,000 1 50
C 3, 50,000 4, 35,000 13 
1 , 4,915, 12 45
F 2,154, ,69, 11 2
 2,3, 9,369, 1 6
A 1,5, 1, 69,  19

c  c
 c    ,
Investment pportunity Schedule
A etailed ample Continued «

##  The remaining projects certainly meet the first

investment screen - that is, they offer rates of return in
ecess of the firm¶s WACC (they have a positive PV)

##  ow we can prepare a graphical representation of the

IS by plotting the projects¶ IRR against the
cumulative dollars of capital to be raised

##  Then we overlay the MCC graph we just saw to

determine which projects provide sufficient returns

c  c
 c    
Investment pportunity Schedule (IS)
A etailed ample Continued «


* ep e° pfpea pyl=erppeqalpp epprepIRR;p epw ppeqalpp ep=alp
=veme=pfrp eppre.

 p%p Ä The upper surface of
) the columns is the
 p%p (
" IS

 p%p 
+ ,
V
 p%p (
 p%p 

## V \$?,VVV,VVV \$,VVV,VVV \$ ,VVV,VVV \$ ,VVV,VVV \$ V,VVV,VVV

Äp!p"pp# p  

c  c
 c    
Investment pportunity Schedule (IS)
A etailed ample Continued «


*

 p%p Ä IS
)
 p%p (
"
 p%p 

V
+ ,
 p%p (  p%p 

## V \$?,VVV,VVV \$,VVV,VVV \$ ,VVV,VVV \$ ,VVV,VVV \$ V,VVV,VVV

Äp!p"pp# p  

c  c
 c    -
MCC Superimposed on the IS
A etailed ample Continued «

## The break in the MCC IRRis B <caused

MCC?
 by the ehaustionso ofthis
low project
cost
* retained earnings and is the need Itto
rejected

 p%p Ä finance project F through willeternal
not
) offering of euity,increase
incurringthe
 p%p (
floatation costs
value of the
" firm
 p%p 
\$""(%p 
V
\$"" %&'""%p + ,
 p%p (  p%p 

## V \$?,VVV,VVV \$,VVV,VVV \$ ,VVV,VVV \$ ,VVV,VVV \$ V,VVV,VVV

Äp!p"pp# p  

c  c
 c    
ivisional Costs of Capital
j ! 






 

 


 

 
  
 

j ?
?..,  ' 
  
) 

 









 
 !

j 
 

,

 

,..
 




 (
,

  

j

 



 




, 
  
 


 

 K




G More on this net class
c  c
 c    
Appendi
Steep Hill Mines

! +%

 
Steep Hill Mines #
The Question

Steep Hill Mines Ltd shares are publicly traded on the Toronto
Stock change The shares currently trade at a price of \$ V VV per
share Security analysts that follow the stock have estimated it's beta
coefficient to be V  Steep Hill paid a dividend on its common stock
last year that totaled \$  V per share ividends have been growing at
a  compound rate for the past si years and the epectation is that
this growth can continue into the foreseeable future

## Steep Hill also has it's long-

long-term bonds trading on public markets
The bonds are currently trading at a discount from their par value of
  These  bonds have ten years left until they mature

## Steep Hill Mines Ltd has an important capital project to consider

Project A is epected to produce annual cash flows after ta of
\$ VV,VVV for the net eight years It is considered to be of similar risk
to the risk of the firm itself It will cost Steep Hill \$VV,VVV this year to
get this project up and running

c  c
 c    
Steep Hill Mines #
The Question «

## Cathy Jones, Steep Hill's manager of finance has collected current

data from the firm's underwriters

## G Government of Canada  -  -day Treasury bills are currently yielding  ? 

G The epected return on the TS VV composite inde is forecast to be  V in
the net year
G ew euity capital could be raised by the firm at the current market price, but
floatation costs would amount of  of the value of the issue
G ew bonds could be sold into the market, but the floatation cost percentage
would be 
G The firm faces a corporate ta rate of V
G The company will seek to sustain the current capital structure based on eisting
market value weights
G If the firm goes ahead with the capital project, it will have to seek eternal
financing since there is no internal cash flow available for reinvestment

## The firm's most recent financial statements are found below:

c  c
 c    
Steep Hill Mines #
The Question «

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F

c  c
 c    
Steep Hill Mines #
The Solution G The uity Investor¶s Reuired Return

&
N
(

  +(#
M Approach:

D
´ ° - 
 - 
KS ´° ´  ´  ( ´  (
P - -

CAPM Approach:

## KS F ´ B . E  F  ( ´ .   (

KS ( ´   (

c  c
 c    ,
Steep Hill Mines #
The Solution G The Cost of uity

&
N
(

  +(
The average of our two estimates for the cost of retained earnings
is: ( ? +  ? )/? *  

## This is the returns our current shareholders are demanding on our

stock
If we raise eternal capital, we will incur floatation costs
(underwriter's fees, legal costs, etc ) This represents 

##  p  p 

"p! p0 p*/  pp
!
 
pppppppppppppppppppppppppppppp ppp      
  

c  c
 c    
Steep Hill Mines #
The Solution

&
N
(

  


 
 
( ´ k )= 
â- B I ´F p
 k  ( ´ k ) =

 
 
  ( ´ k ) ( 
ppp- -()  ´F
 k  ( ´ k ) (
 
ppp 1 #    e ==l ly
ppp 1 #  (   ((

c  c
 c    
Steep Hill Mines #
The Solution G The Cost of ebt

 
 
   
          
       
   
   
>

((
 T ((
 
Kd 
f  

>
  
 

c  c
 c    -
Steep Hill Mines #
The Solution G etermining Market Value Weights

9,
0

#
   
  ;
      
   
 
  
 

 
    ?   -

  
@  @
    <   - 
@  
A? B ?:A9 9   

##        ?   @ @  

       <    -
-    

c  c
 c    
Steep Hill Mines #
The Solution G Market Value WACC

c
 c  :
       
>

Market Spe i i
Sour e o Value Mar inal W ei hte
Capital W ei ht Cost Cost
T e t
re erre
Co on
W ACC 

c  c
 c    
Steep Hill Mines #
The Solution

## Since the project has similar risk characteristics to the

firm as a whole, we do not have to calculate a risk-
risk-
WACC

## Since the market value capital structure weights will be

used by the firm in the long run, let's use that in the
WACC, and calculate the project¶s PV

c  c
 c    
Steep Hill Mines #
The Solution G Project PV

## â--  ( 

N  ´ (
´ 
´    ppp Using uation

´ k
´ k
´ k
 -  for PV,
=
and substituting
 


in the annual
 
 

´ k cash flow
ppppppppp - 2
3+'  )21  &'""  -2 benefits of
\$ VV,VVV after-
ppppppppp - 2
3+'  )21 )  -2
ta, initial cost,
useful life of


) ) years, and
ppppppppp - 2  -2
) WACC of 
ppppppppp - 2
) ))  -2 we find the
project offers a
ppppppppp -)2 )  -2
positive PV
N   - )2 )

c  c
 c    