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**Chapter 13 Learning Objectives**

Calculate a firm’s capital structure. Estimate the required rates of return on the securities issued by the firm. Calculate the weighted-average cost of capital. Understand when the weighted-average cost of capital is -or isn’t- the appropriate discount rate for a new project. Use the weighed-average cost of capital to value a business given forecasts of its future cash flows.

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**The WACC and Company Valuation**

The required rate of return on a firm’s projects can be calculated using the weighted-average cost of capital. The weighted-average cost of capital (WACC) is the after-tax return the company needs to earn in order to satisfy all its security holders. Chapter 13 Outline Company Cost of Capital Capital Structure Weighted Average Cost of Capital 3 Steps for Calculation Using WACC with Multiple Sources of Financing WACC and NPV Measuring Capital Structure Use Market Values Calculating Expected Returns Expected Return on Bonds Expected Return on Common Stock CAPM DDM Expected Return on Preferred Stock WACC Pitfalls Adjust WACC According to Risk Altering Capital Structure Valuing Entire Businesses

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**Company Cost of Capital**

The opportunity cost of capital for the firm’s existing assets. The minimum acceptable rate of return when the firm expands by investing in average-risk projects. Capital Structure The mix of long-term debt and equity financing. Company Cost of Capital – The opportunity cost of capital for the firm’s existing assets. The minimum acceptable rate of return when the firm expands by investing in average-risk projects. Capital Structure – The mix of long-term debt and equity financing. Used to value new assets that have the same risk as the old ones.

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**Company Cost of Capital**

The company cost of capital is a weighted average of returns demanded by debt and equity investors. The weighted average is the expected rate of return investors would demand on a portfolio of all the firm’s outstanding securities. Note: When calculating a firm’s cost of capital, always use market values, not book values.

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**Company Cost of Capital: Example**

Macrosoft, Inc. has issued long-term bonds with a present value of $25 million and a yield of 8%. It currently has 12 million shares outstanding, trading at $20 each, offering an expected return of 14%. What is the firm’s cost of capital?

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**Weighted Average Cost of Capital**

For proper valuation we must value the firm’s after-tax cash flows. Why is it important to account for taxes? The importance of taxes: Most companies are financed by both equity and debt. The interest payments on debt are deducted from income before tax is calculated. Therefore, the cost to the company is reduced by the amount of their tax savings.

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**Weighted Average Cost of Capital**

The WACC provides a firm’s after-tax cost of capital. Weighted Average Cost of Capital (WACC) – Expected rate of return on a portfolio of all the firm’s securities, adjusted for tax savings due to interest payments. Where: Tc = The firm’s average tax rate

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**Calculating WACC A firm’s WACC is calculated in 3 steps:**

Calculate the value of each security as a proportion of firm value. Determine the required rate of return on each security. Calculate a weighted average of the after-tax return on the debt and return on the equity.

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**Calculating WACC: Example**

What is the WACC for a firm with $30 million in outstanding debt with a required return of 8%, 8 million in equity shares outstanding trading at $15 each with a required return of 12%, and a tax rate of 35%? 1. 2. 3.

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**Calculating WACC If the firm issues preferred stock:**

If there are 3 (or more) sources of financing, simply calculate the weighted-average after-tax return of each security type. If the firm issues preferred stock:

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**Calculating WACC: Example**

Consider a firm with $8 million in outstanding bonds, $15 million worth of outstanding common stock, and $5 million worth of outstanding preferred stock. Assume required returns of 8%, 12%, and 10%, respectively, and a 35% tax rate. 1. 2. 3.

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**In our previous example, we calculated the firm’s WACC to be 9.7%**

WACC and NPV In our previous example, we calculated the firm’s WACC to be 9.7% Would NPV be positive or negative if: We invested in a project offering a 9% return? If a project has zero NPV when the expected cash flows are discounted at the WACC, then the project’s cash flows are just sufficient to give debtholders and shareholders the returns they require. We invested in a project offering a 10% return? We invested in a project offering a 9.7% return?

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**Measuring Capital Structure**

When estimating WACC, use market values, not book values. Market Value of Debt Present Value of all coupons and principal, discounted at the current YTM. Market Value of Equity Market price per share multiplied by the number of shares outstanding. Calculating market values: Market value of debt: PV of all coupons and principal, discounted at the current YTM. Market value of equity: Market price per share multiplied by the number of shares outstanding.

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**Measuring Capital Structure: Example**

If a firm’s bonds pay a 5% coupon and mature in 3 years, what is their market value, assuming a 7% yield to maturity? Assume the bond has a $1,000 par value.

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**Calculating Expected Returns**

To calculate the WACC, we must first calculate the rates of return that investors expect from each security. Expected returns on bonds Expected returns on common stock Expected returns on preferred stock

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**Expected Return on Bonds**

The risk of bankruptcy aside, the yield to maturity represents an investor’s expected return on a firm’s bonds.

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**Expected Return on Common Stock**

Estimating requity using CAPM: Example: A firm’s beta is 1.5, Treasury bills currently yield 4%, and the long-run market risk premium is 8%. What is the firm’s cost of equity?

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**Expected Return on Common Stock**

Estimating requity using the DDM: Example: A firm’s shares are trading for $45 per share. The firm is expected to pay a $2 per share dividend at the end of the year. What is its expected return on equity assuming a 9% constant growth rate? Note: The constant-growth formula can only be used for firms that have a stable and predictable growth pattern. Do not use this formula for firms with very high current rates of growth, or firms with unpredictable rates of growth.

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**Expected Return on Preferred Stock**

A preferred stock that pays a fixed annual dividend is no more than a simple perpetuity.

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**Expected Return on Preferred Stock: Example**

If a share of preferred stock sells for $40 and it pays a dividend of $3 per share, what is the expected return on that share of stock?

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**WACC Pitfalls Upward/Downward Adjustments Altering Capital Structure**

The WACC is appropriate only for projects that have the same risk as the firm’s existing business. Upward/Downward Adjustments Altering Capital Structure Two costs of debt finance: Explicit and Implicit Firms that use WACC as a companywide benchmark can adjust the rate upward for unusually risky projects and downward for unusually safe projects. Firms should not arbitrarily alter their capital structure in order to manipulate WACC. If the firm increases its borrowing to lower its WACC, the lenders will likely demand a higher rate of interest on the debt. There are two costs of debt finance: Explicit Cost – the interest rate that bondholders demand. Implicit Cost – borrowing increases the required return on equity.

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**Altering Capital Structure: Example**

What is the WACC for a firm with $100 million in debt requiring a 6% return and $400 million in equity requiring a 10% return? Assume a tax rate of 35%. What if the firm borrows an additional $150 million to retire some of its shares, but investors now demand 9% on the debt and 12% on equity? Firms cannot simply increase their debt holdings in order to decrease their WACC. Eventually both debtholders and shareholders will demand higher rates of return, leading to a higher WACC.

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**Valuing Entire Businesses**

We can treat entire companies like giant projects and value them using the WACC. Free Cash Flow Cash flow that is not required for investment in fixed assets or working capital and is therefore available to investors. Free Cash Flow – Cash flow that is not required for investment in fixed assets or working capital and is therefore available to investors.

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**Valuing Entire Businesses**

The value of an entire business is equal to the discounted value of the free cash flows out to some horizon year plus the forecasted value of the business at the horizon, discounted back to the present.

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**Valuing Entire Businesses: Example**

Use the following information to calculate the value of a business that your firm is considering acquiring. Firm’s WACC: 12.5% Firm’s Cash Flows $1 million FCF, years 1-4 $1.05 million FCF, year 5 5% growth after 4 years

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**Valuing Entire Businesses: Example**

Note: Work through this example using both a financial calculator and a spreadsheet

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Chapter 11 Cost of Capital Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

Chapter 11 Cost of Capital Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.

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