FIN 614: Financial Management Larry Schrenk, Instructor

1.Determining the Weights 2.A Complete Example 3.Using WACC for Valuing… 1.Internal Divisions 2.Projects

Weights represent the percentage raised by each source of financing:

Two Possible Goals: Firm as Currently Financed WACC as Discount Rate for Project Decisions Firm versus Project Weights Book versus Market Past versus Future Actual versus Target

Uncontrollable Factors: Market Conditions, especially Interest Rates Market Risk Premium Tax Rate Controllable Factors: Capital Structure Policy Dividend Policy Investment Policy Firms with riskier projects generally have a higher cost of equity

Investment Amounts Common Stock = $50,000 Bonds = $25,000 Preferred Shares = $25,000 Bond Price = $990 Coupon Rate = 8% Period = Semiannual Maturity = 25 Years Par Value = $1,000 Preferred Stock Price = $85 Dividend = $8 Common Stock Risk-Free Rate (r f ) = 5% Return on Market (r M ) = 12% Beta (  ) = 1.1 Corporate Tax Rate  c = 35%

1.Calculate Weights, w d, w p, w s 2.Calculate Cost of Equity Capital, r s, using CAPM. 3.Calculate Cost of Preferred Capital, r s, using Market Implied Discount Rate 4.Calculate Cost of Debt Capital, r d, using YTM. 5.Calculate WACC.

Price = $990 Coupon Rate = 8% Period = Semiannual Maturity = 25 Years Par Value = $1,000 Yield to Maturity (YTM) N = 50; I% = 8.09%; PV = -990; PMT = -40; FV = -1,000; P/Y = 2

Price = $85 Dividend = $8 Implied Discount Rate

r f = 5% r M = 12%  = 1.1 CAPM

w d = 0.25; w p = 0.25; w s = 0.50 r d = 8.09% r p = 9.41% r s = 12.70%  c = 35%

Composite WACC reflects the risk of an average project undertaken by the firm. Different divisions may have different risks. The division’s WACC should be adjusted to reflect the division’s risk and capital structure.

Estimate the cost of capital as if division were a stand-alone firm. Estimating the division’s beta, cost of debt, and capital structure.

Find several publicly traded companies exclusively in division’s or project’s business. Use average of their betas as proxy for project’s beta. Hard to find such companies.

Regression between project’s ROA and S&P Index ROA. Accounting betas are correlated (0.5 – 0.6) with market betas. Problem: Data on new projects

Target Debt Ratio = 10% r d = 12% r rf = 5.6%  c = 40%  div = 1.7 Market Risk Premium = 6%

Division Required Return on Equity: r s = r rf +  div (r M – r rf ) r s = 5.6% + 1.7(6%) = 15.8%. WACC div = w d r d (1 –  c ) + w s r s = 0.1(12%)(0.6) + 0.9(15.8%) = 14.94%

Division WACC = 14.9% versus company WACC = 10.4% ‘Typical’ projects within this division would be accepted if their returns are above 14.9%.

If project has same financing and risk as the existing business or assets of the firm, use WACC as our discount rate If the new project has very different financing or risk from existing business, WACC must be adjusted (if possible), or Use alternate method to find discount rate

What would happen if we use the WACC for all projects regardless of risk? Assume the WACC = 15% ProjectRequired ReturnExpected Return A20%17% B15%18% C10%12%

You tend to favor more risky projects Mistakenly reject project C and take project A In making such mistakes, the firm becomes more and more risky.

If the project is more (less) risky than the firm, use a discount rate greater (less) than the WACC If the project has different financing than the firm, adjust the weights IMPORTANT: If project weights are significantly different than the firm’s, then this may change required rates of return.

FIN 614: Financial Management Larry Schrenk, Instructor