Chapter 12

Fundamentals of
Corporate The Weighted-Average Cost
Finance of Capital and Company
Valuation
Fifth Edition

Slides by
Matthew Will

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Topics Covered
Geothermal’s 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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12- 3

Cost of Capital

Cost of Capital - The return the firm’s

investors could expect to earn if they
invested in securities with comparable
degrees of risk.

Capital Structure - The firm’s mix of long

term financing and equity financing.

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12- 4

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 $194 30%

Market Value Equity $453 70%
Market Value Assets $647 100%

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12- 6

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 = (.3x8%) + (.7x14%) = 12.2%

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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 = (.3x8%) + (.7x14%) = 12.2%

Interest is tax deductible. Given a 35% tax rate, debt only

costs us 5.2% (i.e. 8 % x .65).

WACC = (.3x5.2%) + (.7x14%) = 11.4%

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WACC

Weighted Average Cost of Capital (WACC)

- The expected rate of return on a portfolio of
all the firm’s securities.

Company cost of capital = Weighted average of debt

and equity returns.

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WACC

rassets = total income

value of investments

(D x rdebt ) + (E x requity )
rassets  V

rassets   x rdebt    x requity 

D
V
E
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.

A fte r - ta x c o s t o f d e b t = p re ta x c o s t x (1 - ta x ra te )
= r d e b t x (1 - T c )

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WACC

Weighted -average cost of capital=

W ACC = [ D
V x (1 - T c )r d e b t + ] [ E
V x r e q u ity ]

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12- 12

WACC

Three Steps to Calculating Cost of Capital

1. Calculate the value of each security as a
proportion of the firm’s 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 = [ 4
12 x(1-.35).06 + ] ( 2
12 x.12 + ) ( 6
12 x.18 )
=.123 or 12.3%

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12- 15

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

Bassets = [
 Betas may change with
D capital structureE
V x Bdebt + ] [ V x Bequity ]
 Corporate taxes complicate the analysis and may change our
decision

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12- 16

Measuring Capital Structure

In estimating WACC, do not use the Book

Value of securities.
In estimating WACC, use the Market Value
of the securities.
Book Values often do not represent the true
market value of a firm’s securities.

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Measuring Capital Structure

Market Value of Bonds - PV of all

coupons and par value discounted at the
current interest rate.

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Measuring Capital Structure

Market Value of Bonds - PV of all

coupons and par value discounted at the
current interest rate.

Market Value of Equity - Market price per

share multiplied by the number of
outstanding shares.

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12- 19

Measuring Capital Structure

Big Oil Book Value Balance Sheet (mil)

Bank Debt $ 200 25.0%
LT Bonds $ 200 25.0%
Common Stock $ 100 12.5%
Retained Earnings $ 300 37.5%
Total $ 800 100%

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Measuring Capital Structure

Big Oil Book Value Balance Sheet (mil)
Bank Debt $ 200 25.0%
If the long term bonds pay an
LT Bonds $ 200 25.0% 8% coupon and mature in 12
Common Stock $ 100 12.5%
Retained Earnings $ 300 37.5% years, what is their market
Total $ 800 100% value assuming a 9% YTM?

16 16 16 216
PV   2
 3
 ....  12
1.09 1.09 1.09 1.09
 $185.70

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Measuring Capital Structure

Big Oil MARKET Value Balance Sheet (mil)

Bank Debt (mil) $ 200.0 12.6%
LT Bonds $ 185.7 11.7%
Total Debt $ 385.7 24.3%
Common Stock $ 1,200.0 75.7%
Total $ 1,585.7 100.0%

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12- 22

Required Rates of Return

Bonds
rd = YTM

Common Stock
re = CAPM
= rf + B(rm - rf )

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Required Rates of Return

Dividend Discount Model Cost of Equity

Perpetuity Growth Model =
Div1
P0 =
re - g

solve for re
Div1
re = + g
P0

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Required Rates of Return

Expected Return on Preferred Stock

Price of Preferred Stock =
Div1
P0 =
rpreferred

solve for preferred

Div1
rpreferred =
P0

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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.

FCF1 FCF2 FCFH PVH

PV    ...  
(1  r ) (1  r )
1 2
(1  r ) H
(1  r ) H

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Capital Budgeting
Valuing a Business or Project

FCF1 FCF2 FCFH PVH

PV    ...  
(1  r ) (1  r )
1 2
(1  r ) H
(1  r ) H

PV (free cash flows) PV (horizon value)

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Capital Budgeting
Example - Concatenator Manufacturing
.

 83.2 
Horizon Value)     2,376.7
 .085  .05 

72.5 87.1 102.9 27.7 43.5 2,376.7

PV(FCF)  -     
1.085 1.085 2 1.085 3 1.085 4 1.085 5 1.085 5
 1,368.20

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