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# Fundamentals of Corporate Finance

Fifth Edition

Chapter 12
The Weighted-Average Cost of Capital and Company Valuation

## Slides by Matthew Will

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## Copyright 2007 by The McGraw-Hill Companies, Inc. All rights

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Topics Covered
Geothermals 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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Cost of Capital
Cost of Capital - The return the firms investors could expect to earn if they invested in securities with comparable degrees of risk. Capital Structure - The firms mix of long term financing and equity financing.

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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?

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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 \$4441% 1 Market Value Equity \$4441% 1 Market Value Assets \$1111% 11
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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 = (.11 + (.111 = 1.1 x %) x %) 1%

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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 = (.11 + (.111 = 1.1 x %) x %) 1%
Interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2% (i.e. 8 % x .65).

## WACC = (.11 %) + (.111 = 1.1 x .1 x %) 1%

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WACC
Weighted Average Cost of Capital (WACC) - The expected rate of return on a portfolio of all the firms securities.
Company cost of capital = Weighted average of debt and equity returns.

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WACC

rassets =
rassets =
D V

## total income value of investment s

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

## rassets = ( x rdebt ) + ( x requity )

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.

After - tax cost o f debt = pretax cos t x (1- tax rate) = rdebt x (1- Tc)

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WACC
Weighted -average cost of capital=

WACC =

D V

x (1- Tc)rdebt +

] [

E V

x requity

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WACC
Three Steps to Calculating Cost of Capital 1. Calculate the value of each security as a proportion of the firms 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 =

1 1 1

x(111 1 + -. ).1

] (

1 1 1

x.44 +

) (

1 1 1

x.44

=.1111.1 or 1 %
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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 E Bassets change withBdebt + V x Bequity = D x capital structure V Betas may

] [

Corporate taxes complicate the analysis and may change our decision
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## 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 firms 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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## Measuring Capital Structure

Big Oil Book Value Balance Sheet (mil) Bank Debt \$ 11 1 4.4 4% LT Bonds \$ 11 1 1.1 1% Common Stock \$ 11 1 1.1 1% Retained Earnings \$ 11 1 4.4 4% Total \$ 11 1 11 1%

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## Measuring Capital Structure

Big Oil Book Value Balance Sheet (mil) Bank Debt \$ 11 1 4.4 4% LT Bonds \$ 11 1 1.1 1% Common Stock \$ 11 1 1.1 1% Retained Earnings \$ 11 1 4.4 4% Total \$ 11 1 11 1%

If the long term bonds pay an 8% coupon and mature in 12 years, what is their market value assuming a 9% YTM?

## 1 1 1 1 1 1 11 1 PV = + + + .... + 1 1 1 1 11 11 11 .1 .1 .1 14 .4 = \$11 1 1.1

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## Measuring Capital Structure

Big Oil MARKET Value Balance Sheet (mil) Bank Debt (mil) \$ 11 1 .1 1 .1 1% LT Bonds \$ 44 4 .4 1 .1 1% Total Debt \$ 11 1 .1 4 .4 4% Common Stock \$ 1 1 .1 ,1 1 1 .1 1% Total \$ 1 1 .1 1 1 % ,1 1 1 .1

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## 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 P1 = re - g
solve for re Div1 re = + g P1
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## Required Rates of Return

Expected Return on Preferred Stock
Price of Preferred Stock =

P1 =
solve for preferred

Div1 rpreferred

rpreferred

Div1 = P1

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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
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 FCF1 FCFH PVH PV = + + ... + + 1 1 H (1 r ) (1 r ) + + (1 r ) + (1 r ) H +

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Capital Budgeting
FCF1 FCF1 FCFH PVH PV = + + ... + + 1 1 H (1 r ) (1 r ) + + (1 r ) + (1 r ) H +
PV (free cash flows) PV (horizon value)

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Capital Budgeting
Example - Concatenator Manufacturing
.

## 1 1.1 Horizon Value) = ,11 = 1 1.1 4 1 .44 .1

PV(FCF) = 1.1 1 1.1 1 11 1 .1 1.1 1 1.1 1 1.1 1 ,11 + + (111 (1111 (1111 (1111 (1111 (1441 . 1) . 1) . 1) . 1) . 1) . 4)

= 1 1.1 ,11 1

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