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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 euity costs
‡ Common euity costs

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The Short Story of WACC
Why the Marginal Cost?

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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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WACC Ke ´ K p ´ K d ( -T) pppppp
â V V V

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The Short Story of WACC
The Spreadsheet Approach

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


 
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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
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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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Cost of uity
Constant Growth Model Caution

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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-
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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 reuires 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 euity

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Y * the risk-
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Y * the market risk premium (RM - Rf )

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Risk--Based Models & the Cost of uity
Risk
stimating the Market Risk Premium

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Risk--Based Models & the Cost of uity
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Using the CAPM to stimate the Cost of Common uity

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Risk--Based Models & the Cost of uity
Risk
Using the CAPM to stimate the Cost of Common uity

Long- un a e age ates of etu n a e mo e eliable

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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

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stimated Betas for Sub Indees of the S&P/TSX Composite Inde

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Risk--Based Models & the Cost of uity
Risk
stimated Betas for Sub Indees of the S&P/TSX Composite Inde

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G ther sub inde betas show constant or decreasing trends

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G If one sub inde is changing«that change alone affects all
others in the opposite direction

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G The internet bubble of the late s resulted in rapid growth in
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using the range of Company betas prior to the bubble
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G Recall that the cost of euity capital is an estimate
which tries to approimate what shareholders reuire
as a return compensating them for the risks they face

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stimating the Component Costs
Floatation Costs

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G Underwriting discounts paid to the investment dealer
G irect costs associated with the issue including legal and
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G et proceeds on the sale of each security is less than what the
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G The component cost of capital > investor¶s reuired return

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stimating the Component Costs
Floatation Costs and the Marginal Cost of Capital (MCC)

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ost of apital eing greater than the in estor¶s reqired retrn.

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Floatation Cost Calculation

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G et Proceeds Method

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Floatation Cost Calculation

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The Component Cost of ebt

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stimating the Component Costs
Preferred Shares

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stimating the Component Costs
Preferred Shares

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uity
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WACC versus MCC
Floatation Costs and the Marginal Cost of Capital (MCC)

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The Marginal Cost of Capital MCC

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$""(%p 
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ach dollar of capital invested up to ach dollar of capital invested
$ million is financed V by beyond $ million is financed
internal euity (R/) ( V × cost V by new euity ( V ×
cost of new euity * )
of retained earnings * ?)
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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

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Investment pportunity Schedule
A etailed ample «

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Investment pportunity Schedule
A etailed ample «

The first step in developing an IS is to order the projects


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

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 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

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Investment pportunity Schedule
A etailed ample Continued «

‡ The remaining projects certainly meet the first


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

‡ ow we can prepare a graphical representation of the


IS 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

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Investment pportunity Schedule (IS)
A etailed ample Continued «


* ep e° pfpea pyl=erppeqalpp epprepIRR;p epw ppeqalpp ep=alp
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" IS

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Investment pportunity Schedule (IS)
A etailed ample Continued «


*


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MCC Superimposed on the IS
A etailed ample Continued «

The break in the MCC IRRis B <caused


MCC?
 by the ehaustionso ofthis
low project
cost
* retained earnings and is the need Itto
rejected


 p%p Ä finance project F through willeternal
not
) offering of euity,increase
incurringthe
   p%p (
floatation costs
value of the
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V $?,VVV,VVV $,VVV,VVV $ ,VVV,VVV $ ,VVV,VVV $ V,VVV,VVV

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ivisional Costs of Capital
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Appendi  
Steep Hill Mines  

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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 epectation 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 epected to produce annual cash flows after ta of
$ VV,VVV for the net 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

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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 epected return on the TS VV composite inde is forecast to be  V in
the net year
G ew euity 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 eisting
market value weights
G If the firm goes ahead with the capital project, it will have to seek eternal
financing since there is no internal cash flow available for reinvestment

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

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Steep Hill Mines #  
The Question «

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Steep Hill Mines #  
The Solution G The uity Investor¶s Reuired Return

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CAPM Approach:

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Steep Hill Mines #  
The Solution G The Cost of uity

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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 eternal capital, we will incur floatation costs
(underwriter's fees, legal costs, etc ) This represents 

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Steep Hill Mines #  
The Solution

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( ´ k )= 
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ppp- -()  ´F
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ppp 1 #    e ==l ly
ppp 1 #  (   (( 

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Steep Hill Mines #  
The Solution G The Cost of ebt

 
 
   
          
       
   
   
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Steep Hill Mines #  
The Solution G etermining Market Value Weights

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Steep Hill Mines #  
The Solution G Market Value WACC

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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 

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Steep Hill Mines #  
The Solution

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Since the project has similar risk characteristics to the


firm as a whole, we do not have to calculate a risk-
risk-
adjust discount rate«instead, we can just use the firm's
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

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Steep Hill Mines #  
The Solution G Project PV

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´ 
´    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 )

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