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The Weighted Average Cost of Capital and Company Valuation Chapter 13 Fundamentals of Corporate Finance 2012 Linköpings universitet 1

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1917 bildades Finanskoncernen Kreuger & Toll Svenska Tändsticks AB, 1930 omfattade 60 % av världens tändsticksproduktion. Kreuger & Toll Pris föll från sin högsta notering i mars 1929 på över 46 dollar till 4,5 dollar i slutet av 1931 1929 depression, och han fick likviditetskris Dock hans imperium blev grunden för många svenska koncernen. 2 Ivar Kreuger omkring 1930 vid sitt skrivbord i Tändstickspalatset

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Cost of Capital Weighted Average Cost of Capital (WACC) Measuring Capital Structure Calculating Required Rates of Return Calculating WACC Interpreting WACC Valuing Entire Businesses 3

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Most companies are financed by a mixture of securities. Including common stock, bonds, and other securities. These securities have different risks, therefore investors require different return on them. Cost of Capital – required rate of return on investment. It is the return the firm’s investors could expect to earn if they invested in other equally risky securities. 4

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Capital Structure - The firm’s mix of debt financing and equity financing. Long term capital structure involves only long term debt and equity Market value of debt and market value of equity corresponds to the market capital structure. This is to differentiate from the book value of debt and equity. 5

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Taxes are an important consideration in the company cost of capital, because interest payments are tax deductible. 6

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Weighted Average Cost of Capital (WACC) The expected rate of return on a portfolio of all the firm’s securities, adjusted for tax savings due to interest payments. Company cost of capital = Weighted average of debt and equity returns. 7

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Weighted Average Cost of Capital = WACC 8

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Three Steps to Calculating Cost of Capital 1. Calculate the proportion of firm´s debt and equity. 2. Determine the required rate of return on equity and debt. 3. Calculate a weighted average after tax return on the debt and equity. 9

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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? 10

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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? 11

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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 Interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2% (i.e. 8 % x.65).

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Weighted Average Cost of Capital with debt, equity and Preferred Stock Preferred stock provides a specific dividend that is paid before any dividends are paid to common stock. 14 Where D is the value of debt, E is the value of equity, P is preferred stock, τ is tax rate.

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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. 15

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Example - continued Step 1 Firm Value = = $12 mil Step 2 Required returns are given Step 3 16

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17 Market Value of Bonds – Present Value of all coupons and par value discounted at the current yield to maturity, YTM. Market Value of Equity - Market price per share multiplied by the number of outstanding shares.

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18 Page 374/5 Example: Suppose Long term bond has a coupon payment of 8%, 12 year to maturity. Common stocks 100 million shares valued at 12 $ each

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19 If the long term bonds pay an 8% coupon and mature in 12 years, market interest rate is 9%, what is the market value of the bonds?

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On Bonds 21 On Common Stock That is, expected return on stock is equal to risk free return plus beta times market risk premium.

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Dividend Discount Model (DDM) Constant Dividend Growth Model = solve for r e 22

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Expected Return on Preferred Stock Price of Preferred Stock = solve for preferred 23

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Expected returnInterest rateProportion of on equity (%)on debt (%)Equity (E/V)Debt (D/V)WACC (%)Mkt CapTotl debt Amazon.com Ford Newmont Mining Intel Microsoft10.3na Dell Computer Boeing McDonalds Pfizer Dupont Disney ExxonMobil IBM Wal-Mart Campbell Soup GE Heinz Notes:1. Expected return on equity is taken from Table Interest rate on debt is calculated from yields on similarly rated bonds 3. D is the book value of the firm's debt,and E is the market value of equity 4. WACC = (1 -.35) x r debt x (D/V) + r equity x (E/V) 24

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The WACC is an appropriate discount rate only for a project that is the same of the firm's existing business There are two costs of debt financing. The explicit cost of debt is the rate of interest bondholders demand. The implicit cost is the increased required return from equity due to increased bankruptcy probability. 25

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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 of bankruptcy Betas may change with capital structure Corporate taxes complicate the analysis and may change our decision 26

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Free Cash flow is cash flow that is available to investors, FCF= operating cash flow - investment expenditures. FCF is a more accurate measurement of PV than either Dividend or Earnings per share EPS. Free Cash Flows (FCF) should be the theoretical basis for all PV calculations. When valuing a business for purchase, always use FCF. 27

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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 present value of growth opportunity (PVGO). 28

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Valuing a Business or Project 29 PV (free cash flows)PV (horizon value)

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See P 382/3, Example - Concatenator Manufacturing, cash flows are provided as follows: y1=-73,6 y2=-87,1 y3=-102,9 Y4=-34,1 y5=40,2 y6=79,5 with a discount rate 8,5%, and a steady growth of 5% from year 5 onwards. 30

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