1. Chapter 13 The Weighted Average Cost of Capital and Company Valuation
Fundamentals of Corporate Finance
Sixth Edition
Richard A. Brealey
Stewart C. Myers
Alan J. Marcus
Chapter 13
The Weighted Average Cost of Capital and Company Valuation
Slides by
Matthew Will
McGraw Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved

2. 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 2

3. 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. 3

4. 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? 4

5. 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? 5

6. 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? 6

7. 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?
Interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2% (i.e. 8 % x .65). 6

8. WACC
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

9. WACC 10

10. WACC
Taxes are an important consideration in the company cost of capital because interest payments are deducted from income before tax is calculated. 12

11. WACC
Weighted Average Cost of Capital = WACC 13

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 after tax return on the debt and the return on the equity. 11

13. Weighted Average Cost of Capital with Preferred Stock
WACC
Weighted Average Cost of Capital with Preferred Stock 13

14. 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. 14

15. WACC Example - continued Step 1 Firm Value = 4 + 2 + 6 = $12 mil
Required returns are given
Step 3 17

16. Measuring Capital Structure
In estimating WACC, do not use the Book Value of securities.
In estimating WACC, use the Market Value of the securities.
Book Values often do not represent the true market value of a firm’s securities. 19

17. Measuring Capital Structure
Market Value of Bonds - PV of all coupons and par value discounted at the current YTM.
Market Value of Equity - Market price per share multiplied by the number of outstanding shares. 20

18. Measuring Capital Structure21

19. Measuring Capital Structure
If the long term bonds pay an 8% coupon and mature in 12 years, what is their market value assuming a 9% YTM? 21

20. Measuring Capital Structure21

21. Required Rates of Return
Bonds
Common Stock 23

22. Required Rates of Return
Dividend Discount Model Cost of Equity
Perpetuity Growth Model =
solve for re 25

23. Required Rates of Return
Expected Return on Preferred Stock
Price of Preferred Stock =
solve for preferred 27

24. WACC for Selected Firms
Expected return
Interest rate
Proportion of
on equity (%)
on debt (%)
Equity (E/V)
Debt (D/V)
WACC (%)
Mkt Cap
Totl debt
Amazon.com
19.8
7.3
0.96
0.04
19.3
33.8
1.2
Ford
20.2
7.7
0.07
0.93
6.1
12.2
163.2
Newmont Mining
8.9
6.5
0.89
0.11
8.4
24.2
3.0
Intel
14.1
5.8
0.98
0.02
13.9
111.2
2.0
Microsoft
10.3 na
1.00
0.00
311.7
0.0
Dell Computer
11.9
6.0
0.99
0.01
11.8
47.8
0.7
Boeing
11.6
0.88
0.12
10.7
62.4
8.6
McDonalds
13.1
5.9
12.1
62.5
7.8
Pfizer
5.3
0.95
0.05
7.5
159.3
8.7
Dupont
11.7
0.81
0.19
10.2
38.9
9.0
Disney
10.0
0.78
0.22
55.5
15.5
ExxonMobil
465.0
IBM
10.9
0.80
0.20
9.5
140.7
35.3
Wal-Mart
4.7
5.7
4.5
190.0
47.4
Campbell Soup
6.2
0.82
0.18
12.6
2.8 GE
8.3
0.41
0.59
5.4
344.0
491.0
Heinz
7.1
6.7
0.73
0.27
6.4
14.3
Notes:
1. Expected return on equity is taken from Table 12-2
2. 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 = ( ) x rdebt x (D/V) + requity x (E/V)

25. Interpreting WACC
The WACC is an appropriate discount rate only for a project that is a carbon copy 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 required increase in return from equity.

26. 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
Betas may change with capital structure
Corporate taxes complicate the analysis and may change our decision 18

27. * 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.

28. 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.

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

30. Capital Budgeting
Example - Concatenator Manufacturing

31. Web Resources www.valuepro.net http://pages.stern.nyu.edu/~adamodar