Chapter 13

Advanced Corporate Finance

Prof. GOHAR G. STEPANYAN
Chapter Outline
13. 1 A First Look at the Weighted Average Cost of
Capital
13.2 The Firm’s Costs of Debt and Equity Capital
13.3 A Second Look at the Weighted Average Cost of
Capital
13.4 Using the WACC to Value a Project
13.5 Project-Based Costs of Capital
13.6 When Raising External Capital Is Costly

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Learning Objectives
Understand the drivers of the firm’s overall cost of
capital
Measure the costs of debt, preferred stock, and
common stock
Compute a firm’s overall, or weighted average, cost of
capital

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Learning Objectives
Apply the weighted average cost of capital to value
projects
Adjust the cost of capital for the risk associated with
the project
Account for the direct costs of raising external capital

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13.1 A First Look at the Weighted
Average Cost of Capital
The Firm’s Capital Structure
Capital – a firm’s sources of financing, which usually
consist of debt and equity
Capital structure – the relative proportions of debt,
equity, and other securities that a firm has outstanding

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Figure 13.1 A Basic Balance Sheet

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Figure 13.2 Two Capital Structures

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13.1 A First Look at the Weighted
Average Cost of Capital
Opportunity Cost and the Overall Cost of Capital
Weighted Averages and the Overall Cost of Capital
Weighted Average Cost of Capital (WACC)
Market-Value Balance Sheet

Market Value of Equity (capitaux propres) + Market Value of

Debt =
Market Value of Assets

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13.1 A First Look at the Weighted
Average Cost of Capital
Weighted Average Cost of Capital Calculations
Leverage -> Effet levier
 Unlevered firm
 Levered firm

The Weighted Average Cost of Capital: Unlevered

Firm
r = Equity Cost of Capital
WACC

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13.1 A First Look at the Weighted
Average Cost of Capital
The Weighted Average Cost of Capital: Levered Firm

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Example 13.1 Calculating the
Weights in the WACC
Problem:
 Suppose Kenai Corp. has debt with a book (face) value of $10 million,
trading at 95% of face value. It also has book equity of $10 million, and
1 million shares of common stock trading at $30 per share. What
weights should Kenai use in calculating its WACC?

Solution:
 $10 million in debt trading at 95% of face value is $9.5 million in
market value. One million shares of stock at $30 per share is $30
million in market value. So, the total value of the firm is $39.5 million.
The weights are:
9.5 ÷ 39.5 = 24.1% for debt and 30 ÷ 39.5 = 75.9% for equity
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Example 13.1 Calculating the
Weights in the WACC
Evaluation:
 When calculating its overall cost of capital, Kenai will use a weighted
average of the cost of its debt capital and the cost of its equity capital,
giving a weight of 24.1% to its cost of debt and a weight of 75.9% to its
cost of equity.
 The weights should be based on market values because the cost of
capital is based on investors’ current assessment of the value of the
firm, not their assessment of accounting-based book values. As a
consequence, we can ignore the book values (valeur comptable) of
debt and equity.

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13.2 The Firm’s Costs of Debt and
Equity Capital
Cost of Debt Capital
Yield to Maturity and the Cost of Debt
 The Yield to Maturity is the yield that bond purchasers
would earn if they held the debt to maturity and received
all the payments as promised
 Can use it to estimate the firms current cost of debt: the

yield that investors demand to hold(detemir), bb

the firm’s debt (new or existing)
Taxes and the Cost of Debt
 Effective Cost of Debt: rD (1  TC), where TC is the corporate
tax rate.
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Example 13.2 Effective Cost of
Debt
Problem:
 By using the yield to maturity on DuPont’s debt, we found that its pre-
tax cost of debt is 2.81%. If DuPont’s tax rate is 35%, what is its
effective cost of debt?

Solution:
rD = 2.81% (pre-tax cost of debt)
TC = 35% (corporate tax rate
 DuPont’s effective cost of debt is
0.0281 (1 0.35) = 0.01827 = 1.827%.

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Example 13.2 Effective Cost of
Debt
Evaluation:
 For every $1000 it borrows, DuPont pays its bondholders 0.0281($1000)
= $28.10 in interest every year. Because it can deduct that $28.10 in
interest from its income, every dollar in interest saves DuPont 35
cents in taxes, so the interest tax deduction reduces the firm’s tax
payment to the government by 0.35($28.10) = $9.83. Thus, DuPont’s
net cost of debt is the $28.10 it pays minus the $9.83 in reduced tax
payments, which is $18.27 per $1000 or 1.827%.

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13.2 The Firm’s Costs of Debt and
Equity Capital
Cost of Preferred Stock Capital

Prefered Dividend Div pfd

Cost of Preferred Stock Capital = 
Preferred Stock Price Ppfd

 Assume DuPont’s class A preferred stock has a price of

$85.83 and an annual dividend of $3.50. Its cost of
preferred stock, therefore, is $3.50 ÷ $85.83 = 4.08%

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13.2 The Firm’s Costs of Debt and
Equity Capital
Cost of Common Stock Capital
Capital Asset Pricing Model
1. Estimate the firm’s beta of equity, typically by regressing 60
months of the company’s returns against 60 months of
returns for a market proxy such as the S&P 500
2. Determine the risk-free rate, typically by using the yield on
Treasury bills or bonds
3. Estimate the market risk premium, typically by comparing
historical returns on a market proxy to contemporaneous
risk-free rates
4. Apply the CAPM:
Cost of Equity = Risk-Free Rate + Equity Beta × Market Risk Premium
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13.2 The Firm’s Costs of Debt and
Equity Capital
Cost of Common Stock Capital
Capital Asset Pricing Model
 Assume the equity beta of DuPont is 1.60, the yield on
ten-year Treasury notes is 3%, and you estimate the
market risk premium to be 6%. DuPont’s cost of equity
is 3% + 1.60 × 6% = 12.6%

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13.2 The Firm’s Costs of Debt and
Equity Capital
Cost of Common Stock Capital
Constant Dividend Growth Model

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13.2 The Firm’s Costs of Debt and
Equity Capital
Cost of Common Stock Capital
Constant Dividend Growth Model
 Assume in mid-2013, the average forecast for DuPont’s
long-run earnings growth rate was 7.9%. With an expected
dividend in one year of $1.80 and a price of $57.66, the
CDGM estimates DuPont’s cost of equity as follows:

Div1 $1.80
Cost of Equity = g  0.079  0.110 or 11.0%
PE $57.66

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21
Example 13.3 Estimating the Cost
of Equity
Problem:
 Assume the equity beta for Johnson & Johnson (ticker: JNJ) is 0.55.
The yield on 10-year treasuries is 3%, and you estimate the market risk
premium to be 6%. Furthermore, Johnson & Johnson issues dividends
at an annual rate of $2.81. Its current stock price is $92.00, and you
expect dividends to increase at a constant rate of 4% per year.
Estimate J&J’s cost of equity in two ways.

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Example 13.3 Estimating the Cost
of Equity
Solution:
Risk-free rate: 3% Current price: $92.00
Equity beta: 0.55 Expected dividend: $2.81
Market risk premium: 6% Estimated future dividend
growth rate: 4%
 The two ways to estimate J&J’s cost of equity are to use the CAPM and the
CDGM.
1. The CAPM requires the risk-free rate, an estimate of the equity’s
beta, and an estimate of the market risk premium. We can use the
yield on ten-year Treasury bills as the risk-free rate.
2. The CDGM requires the current stock price, the expected dividend
next year, and an estimate of the constant future growth rate for
the dividend.

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 Example 13.3 Estimating the Cost
of Equity
Solution:
The CAPM says that

Cost of Equity = Risk-Free Rate  Equity Beta  Market Risk Premium

For J&J, this implies that its cost of equity is:

3% + 0.55 × 6% = 6.3%

The CDGM says

Dividend (in one year) $2.81
Cost of Equity   Dividend Growth Rate   4%  7.1%
Current Price $92.00

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Example 13.3 Estimating the Cost
of Equity
Evaluation:
 According to the CAPM, the cost of equity capital is 6.3%; the CDGM
produces a result of 7.1%. Because of the different assumptions we
make when using each method, the two methods do not have to
produce the same answer—in fact, it would be highly unlikely that
they would. When the two approaches produce different answers, we
must examine the assumptions we made for each approach and
decide which set of assumptions is more realistic. We can also see
what assumption about future dividend growth would be necessary to
make the answers converge. By rearranging the CDGM and using the
cost of equity we estimated from the CAPM, we have:
Dividend (in one year)
Dividend Growth Rate  Cost of Equity 
Current Price
 6.3%  3.1%  3.2%
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13.3 A Second Look at the
Weighted Average Cost of Capital
WACC Equation
rwacc = rEE% + rpfd P% + rD(1  TC)D%

For a company that does not have preferred stock, the

WACC condenses to:

rwacc = rEE% + rD(1  TC)D%

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13.3 A Second Look at the
Weighted Average Cost of Capital
WACC Equation
In mid-2013, the market values of DuPont’s common
stock, preferred stock, and debt were $53,240 million,
$221 million, and $14,080 million, respectively. Its total
value was, therefore, $53,240 million + $221 million +
$14,080 million = $67,541. Given the costs of common
stock, preferred stock, and debt we have already
computed, DuPont’s WACC in late mid-2013 was:

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13.3 A Second Look at the
Weighted Average Cost of Capital
WACC Equation

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Example 13.4 Computing the
WACC
Problem:
 Assume the expected return on Target’s equity is 11.5%, and the firm
has a yield to maturity on its debt of 6%. Debt accounts for 18% and
equity for 82% of Target’s total market value. If its tax rate is 35%,
what is this firm’s WACC?

Solution:

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Example 13.4 Computing the
WACC
Evaluation:
 Even though we cannot observe the expected return of Target’s
investments directly, we can use the expected return on its equity and
debt and the WACC formula to estimate it, adjusting for the tax
advantage of debt. Target needs to earn at least a 10.1% return on its
investment in current and new stores to satisfy both its debt and
equity holders.

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Figure 13.3 WACCs for Real
Companies

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13.3 A Second Look at the
Weighted Average Cost of Capital
Methods in Practice
Net Debt
 Net Debt = Debt – Cash and Risk-Free Securities

 Market Value of Equity   Net Debt 

rWACC = rE    rD (1  TC )  
 Enterprise Value   Enterprise Value 

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13.3 A Second Look at the
Weighted Average Cost of Capital
Methods in Practice
The Risk-Free Interest Rate
 Most firms use the yields on long-term treasury bonds
The Market-Risk Premium
 Since 1926, the S&P 500 has produced an average return of
7.7% above the rate for one-year Treasury securities
 Since 1962, the S&P 500 has shown an excess return of only

5.5% over the rate for one-year Treasury securities

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Table 13.2 Historical Excess Returns of the
S&P 500 Compared to One-Year Treasury
Bills and Ten-Year U.S. Treasury Securities

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13.4 Using the WACC to Value a
Project
Levered Value
The value of an investment, including the benefit of the
interest tax deduction, given the firm’s leverage policy
WACC Valuation Method
Discounting (actualization) future incremental
(surcoût) free cash flows using the firm’s WACC, which
produces the levered value of a project:

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Example 13.5 The WACC Method
Problem:
 Suppose Anheuser-Busch InBev is considering introducing a new
ultra-light beer with zero calories to be called BudZero. The firm
believes that the beer’s flavor and appeal to calorie-conscious drinkers
will make it a success. The cost of bringing the beer to market is $200
million, but Anheuser-Busch InBev expects first year incremental free
cash flows from BudZero to be $100 million and to grow at 3% per year
thereafter. If Anheuser-Busch InBev’s WACC is 5.7%, should it go
ahead with the project?

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Example 13.5 The WACC Method
Solution:
 The cash flows for BudZero are a growing perpetuity. Applying the
growing perpetuity formula with the WACC method, we have:

Evaluation:
 The BudZero project has a positive NPV because it is expected to
generate a return on the $200 million far in excess of Anheuser-Busch
InBev’s WACC of 5.7%. Taking positive-NPV projects adds value to
the firm. Here, we can see that the value is created by exceeding the
required return of the firm’s investors.

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13.4 Using the WACC to Value a
Project
Key Assumptions
Average Risk
 We assume initially that the market risk of the project is
equivalent to the average market risk of the firm’s
investments
Constant Debt-Equity Ratio
 We assume that the firm adjusts its leverage continuously
to maintain a constant ratio of the market value of debt to
the market value of equity

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13.4 Using the WACC to Value a
Project
Key Assumptions
Limited Leverage Effects
 We assume initially that the main effect of leverage on
valuation follows from the interest tax deduction and that
any other factors are not significant at the level of debt
chosen

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13.4 Using the WACC to Value a
Project
Key Assumptions
Assumptions in Practice
 These assumptions (hypothèse) are reasonable for many
projects and firms
 The first assumption is likely to fit typical projects of firms

with investments concentrated in a single industry

 The second assumption reflects the fact that firms tend to

increase their levels of debt as they grow larger

 The third assumption is especially relevant for firms without

very high levels of debt where the interest tax deduction is

likely to be the most important factor affecting the capital
budgeting decision
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13.4 Using the WACC to Value a
Project
WACC Method Application: Extending the Life of a
DuPont Facility
Suppose DuPont is considering an investment that
would extend the life of one of its chemical facilities for
four years
The project would require upfront costs of $6.67 million
plus a $24 million investment in equipment
The equipment will be obsolete in four years and will
be depreciated via the straight-line method over that
period

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13.4 Using the WACC to Value a
Project
WACC Method Application: Extending the Life of a
DuPont Facility
During the next four years, however, DuPont expects
annual sales of $60 million per year from this facility
Material costs and operating expenses are expected to
total $25 million and $9 million, respectively, per year
DuPont expects no net working capital requirements
for the project, and it pays a corporate tax rate of 35%.

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Table 13.3 Expected Free Cash
Flow from DuPont’s Facility Project

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13.4 Using the WACC to Value a
Project
WACC Method Application: Extending the Life of a
DuPont Facility
19 19 19 19
V0L   2
 3
 4
 $59.80 million
1.1033 1.1033 1.1033 1.1033

 NPV = $59.80 million - $28.34 million = $31.46 million

 This project is a good idea!

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13.4 Using the WACC to Value a
Project
Summary of WACC Method
1. Determine the incremental free cash flow of the
investment
2. Compute the weighted average cost of capital
3. Compute the value of the investment, including the
tax benefit of leverage, by discounting the
incremental free cash flow of the investment using
the WACC

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13.5 Project-Based Costs of Capital
Cost of Capital of a New Acquisition
Suppose DuPont is considering acquiring Nike, a
company that is focused on the athletic shoe business
Nike faces different market risks than DuPont does in
its chemicals business
What cost of capital should DuPont use to value a
possible acquisition of Nike?

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13.5 Project-Based Costs of Capital
Cost of Capital of a New Acquisition
Because the risks are different, DuPont’s WACC would
be inappropriate for valuing Nike
Instead, DuPont should calculate and use Nike’s WACC
when assessing the acquisition

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13.5 Project-Based Costs of Capital
Divisional Costs of Capital
Now assume DuPont decides to create an athletic shoes
division internally, rather than buying Nike
What should the cost of capital for the new division be?
 IfDuPont plans to finance the division with the same
proportion of debt as is used by Nike, then DuPont would
use Nike’s WACC as the WACC for its new division

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Example 13.6 A Project in a New
Line of Business
Problem:
 You are working for Microsoft evaluating the possibility of selling
digital video recorders (DVRs). Microsoft’s WACC is 8.6%. DVRs
would be a new line of business for Microsoft, however, so the
systematic risk of this business would likely differ from the systematic
risk of Microsoft’s current business. As a result, the assets of this new
business should have a different cost of capital. You need to find the
cost of capital for the DVR business. Assuming that the risk-free rate
is 3% and the market risk premium is 6%, how would you estimate the
cost of capital for this type of investment?

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Example 13.6 A Project in a New
Line of Business
Solution:
 The first step is to identify a company operating in Microsoft’s
targeted line of business. TiVo, Inc., is a well-known marketer of
DVRs. In fact, that is its sole business. Thus, the cost of capital for
TiVo would be a good estimate of the cost of capital for Microsoft’s
proposed DVR business. Many Web sites are available that provide
betas for traded stocks, including http://finance.yahoo.com.
 Suppose you visit that site and find that the beta of TiVo stock is 1.45.
With this beta, the risk-free rate, and the market risk premium, you
can use the CAPM to estimate the cost of equity for TiVo. Fortunately
for us, TiVo has no debt, so its cost of equity is the same as its cost of
capital for its assets.

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Example 13.6 A Project in a New
Line of Business
Solution:
 Using the CAPM, we have:

 Because TiVo has no debt, its WACC is equivalent to its cost of equity .

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Example 13.6 A Project in a New
Line of Business
Evaluation:
 The correct cost of capital for evaluating a DVR investment
opportunity is 11.7%. If we had used the 8.6% cost of capital that is
associated with Microsoft’s existing business, we would have
mistakenly used too low of a cost of capital. That could lead us to go
ahead with the investment, even if it truly had a negative NPV.

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13.6 When Raising External Capital
Is Costly
Issuing new equity or bonds carries a number of costs
Issuing costs should be treated as cash outflows that are
necessary to the project
They can be incorporated as additional costs (negative
cash flows) in the NPV analysis

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Example 13.7 Evaluating an Acquisition
with Costly External Financing
Problem:
 You are analyzing DuPont’s potential acquisition of Nike. DuPont
plans to offer $65 billion as the purchase price for Nike, and it will
need to issue additional debt and equity to finance such a large
acquisition. You estimate that the issuance costs will be $800 million
and will be paid as soon as the transaction closes. You estimate the
incremental free cash flows from the acquisition will be $3.3 billion in
the first year and will grow at 3% per year thereafter. What is the NPV
of the proposed acquisition?

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Example 13.7 Evaluating an Acquisition
with Costly External Financing
Solution:
 We know that the correct cost of capital for this acquisition is Nike’s
WACC. We can value the incremental free cash flows as a growing
perpetuity:

 The NPV of the transaction, including the costly external financing, is

the present value of this growing perpetuity net of both the purchase
cost and the transaction costs of using external financing.

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Example 13.7 Evaluating an Acquisition
with Costly External Financing
Evaluation:
 It is not necessary to try to adjust Nike’s WACC for the issuance costs
of debt and equity. Instead, we can subtract the issuance costs from
the NPV of the acquisition to confirm that the acquisition remains a
positive-NPV project even if it must be financed externally.

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Chapter Quiz
1. Why do we use market value weights in the
weighted average cost of capital?
2. What are the major tradeoffs in using the CAPM
versus the CDGM to estimate the cost of equity?
3. Why do different companies have different WACCs?
4. What inputs do you need to be ready to apply the
WACC method?
5. What types of additional costs does a firm incur
when accessing external capital?

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