Chapter 2: The Cost of Capital
Weighted Average Cost of Capital (pt1)
- 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
WACC = w d∗r d ( 1−t ) +w e∗r e
D = Cost of Debt ------- R = Return / Interest --------- T = Tax
Weighted Average and the Overall Cost of Capital
Weighted Average Cost of Capital (WACC)
(its use to see if new project can be launch)
Market Value of Equity + Market Value of Debt = Market Value of Assets
Weighted Average Cost of Capital Calculations
- Leverage
Unlevered firm
Levered firm
The Weighted Average Cost of Capital: Unlevered Firm
- rWACC = Equity Cost of Capital
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 firm's current cost of debt: the yield that
investors demand to hold 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.
Cost of Preferred Stock Capital
Cost of preferred stock = annuel dividend / net proceeds per share
Net proceeds per share = market price per share – floatation cost per share
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%
Cost of Common Stock Capital -> determination de RE
- Capital Asset Pricing Model: Method 1
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
- Constant Dividend Growth Model: Method 2
Weighted Average Cost of Capital (pt2)
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%
Methods in Practice
Net Debt
Net Debt = Debt – Cash and Risk-Free Securities
The Risk-Free Interest Rate
Most firms use the yields on long-term treasury bonds
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 -> levered value
Discounting future incremental free cash flows using the firm’s WACC, which
produces the levered value of 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
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
Assumptions in Practice
These assumptions 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
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
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.
APV:
The adjusted present value is the net present value (NPV) of a project or company if
financed solely by equity plus the present value (PV) of any financing benefits,