Fundamentals of Corporate Finance Chapter 12 The Weighted-Average Cost of Capital and Company Valuation Fifth Edition Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 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 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 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 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 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? McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 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 Market Value Equity Market Value Assets McGraw-Hill/Irwin 30% $453 70% $647 100% Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 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% McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 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 % x 65) WACC = (.3x5.2%) + (.7x14%) = 11.4% McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 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 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- WACC rassets = rassets = total income value of investments (D x rdebt ) + (E x requity ) V rassets = ( x rdebt ) + ( x requity ) D V McGraw-Hill/Irwin E V Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 10 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 of debt = pretax cost x (1 - tax rate) = rdebt x (1 - Tc) McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 14 WACC Example - continued Step Firm Value = + + = $12 mil Step Required returns are given Step WACC = [ 12 ] ( x(1-.35).06 + 12 ) ( x.12 + 12 =.123 or 12.3% McGraw-Hill/Irwin ) x.18 Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 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 D E B = x B + V x Bequity debt Betas assets may changeV with capital structure [ ] [ ] Corporate taxes complicate the analysis and may change our decision McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 16 Measuring Capital Structure In estimating WACC, not use the Book Value of securities In estimating WACC, use the Market Value of the securities Book Values often not represent the true market value of a firm’s securities McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 17 Measuring Capital Structure Market Value of Bonds - PV of all coupons and par value discounted at the current interest rate McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 18 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 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 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% McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 20 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% If the long term bonds pay an 8% coupon and mature in 12 years, what is their market value assuming a 9% YTM? 16 16 16 216 PV = + + + + 12 1.09 1.09 1.09 1.09 = $185.70 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 21 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% McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 22 Required Rates of Return Bonds rd = YTM Common Stock re = CAPM = rf + B(rm - rf ) McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 23 Required Rates of Return Dividend Discount Model Cost of Equity Perpetuity Growth Model = Div1 P0 = re - g solve for re McGraw-Hill/Irwin Div1 re = + g P0 Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 24 Required Rates of Return Expected Return on Preferred Stock Price of Preferred Stock = P0 = Div1 rpreferred solve for preferred rpreferred McGraw-Hill/Irwin Div1 = P0 Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 25 * 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 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 26 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 = + + + + H (1 + r ) (1 + r ) (1 + r ) (1 + r ) H McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 27 Capital Budgeting Valuing a Business or Project FCF1 FCF2 FCFH PVH PV = + + + + H (1 + r ) (1 + r ) (1 + r ) (1 + r ) H PV (free cash flows) McGraw-Hill/Irwin PV (horizon value) Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 12- 28 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 − − − + + (1.085) (1.085) (1.085) (1.085) (1.085) (1.085) = 1,368.20 PV(FCF) = - McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved [...]... use the Market Value of the securities Book Values often do not represent the true market value of a firm’s securities McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 12- 17 Measuring Capital Structure Market Value of Bonds - PV of all coupons and par value discounted at the current interest rate McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies,... -average cost of capital= WACC = McGraw- Hill/Irwin [ D V ] [ x (1 - Tc)rdebt + E V ] x requity Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 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... reserved 12- 22 Required Rates of Return Bonds rd = YTM Common Stock re = CAPM = rf + B(rm - rf ) McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 12- 23 Required Rates of Return Dividend Discount Model Cost of Equity Perpetuity Growth Model = Div1 P0 = re - g solve for re McGraw- Hill/Irwin Div1 re = + g P0 Copyright © 2007 by The McGraw- Hill Companies, Inc All... McGraw- Hill Companies, Inc All rights reserved 12- 18 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 McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 12- 19 Measuring Capital Structure Big Oil Book... 2)increased cost of equity demanded due to the increase in risk D E B = x B + V x Bequity debt Betas assets may changeV with capital structure [ ] [ ] Corporate taxes complicate the analysis and may change our decision McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 12- 16 Measuring Capital Structure In estimating WACC, do not use the Book Value of securities... 12- 24 Required Rates of Return Expected Return on Preferred Stock Price of Preferred Stock = P0 = Div1 rpreferred solve for preferred rpreferred McGraw- Hill/Irwin Div1 = P0 Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 12- 25 * 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... either Div or EPS The market price does not always reflect the PV of FCF When valuing a business for purchase, always use FCF McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 12- 26 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... 12 1.09 1.09 1.09 1.09 = $185.70 McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 12- 21 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% McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights... these required returns McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 12- 13 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 McGraw- Hill/Irwin Copyright... + + 1 2 H (1 + r ) (1 + r ) (1 + r ) (1 + r ) H McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 12- 27 Capital Budgeting Valuing a Business or Project FCF1 FCF2 FCFH PVH PV = + + + + 1 2 H (1 + r ) (1 + r ) (1 + r ) (1 + r ) H PV (free cash flows) McGraw- Hill/Irwin PV (horizon value) Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 12-