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Chapter 12Fundamentals of
Corporate FinanceFourth Edition
The Cost of Capital
Slides by
Matthew Will
Irwin/McGraw Hill Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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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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