Fundamentals of corporate finance 5e mcgraw chapter 012

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-