3. the cost of capital_2

Chapter 12Fundamentals of

Corporate FinanceFourth Edition

The Cost of Capital

Slides by

Matthew Will

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Topics Covered

Geothermal’s Cost of CapitalWeighted Average Cost of Capital

(WACC)Capital StructureRequired Rates of ReturnBig Oil’s WACCInterpreting WACCFlotation Costs

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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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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?

100%$647Assets ValueMarket

70%$453 EquityValueMarket

30%$194 DebtValueMarket

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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?

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

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

Interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2% (i.e. 8 % x .65).

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

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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

V

)r x (E+)r x (D

assetsequitydebtr

equityVE

debtVD

assets rx rx r

sinvestment of valueincome total

assets =r

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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

Taxes are an important consideration in the company cost of capital because interest payments are deducted from income before tax is calculated.

A f te 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 r a te )

= r x (1 - T c )d e b t

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WACC

Weighted -average cost of capital=

[ ] [ ]W A C C = x ( 1 - T c ) r + x rDV d e b t

EV e q u i ty

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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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WACCExample - continued

Step 1

Firm Value = 4 + 2 + 6 = $12 mil

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WACCExample - continued

Step 1

Firm Value = 4 + 2 + 6 = $12 mil

Step 2

Required returns are given

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WACCExample - continued

Step 1

Firm Value = 4 + 2 + 6 = $12 mil

Step 2

Required returns are given

Step 3

[ ] ( ) ( )WACC = x(1-.35).06 + x.12 + x.18

=.123 or 12.3%

412

212

612

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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

Betas may change with capital structure

Corporate taxes complicate the analysis and may change our

decision

[ ] [ ]B = x B + x BassetsDV debt

EV equity

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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 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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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%

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

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%

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

70.185$09.1

216....

09.1

16

09.1

16

09.1

161232

PV

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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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Required Rates of Return

Bondsr = YTMd

r = CAPM

= r + B(r - r )e

f m f

Common Stock

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Required Rates of Return

Dividend Discount Model Cost of EquityPerpetuity Growth Model =

solve for re

P =Div

r - g01

e

r =Div

P+ ge

1

0

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Required Rates of Return

Expected Return on Preferred StockPrice of Preferred Stock =

solve for preferred

P =Div

r01

preferred

r =Div

Ppreferred1

0

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Flotation Costs

The cost of implementing any financing decision must be incorporated into the cash flows of the project being evaluated.

Only the incremental costs of financing should be included.

This is sometimes called Adjusted Present Value.

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