1. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 1 Cost of Capital Cost of Capital - The return the firm’s investors could expect to earn if they invested in securities (i.e., a package of equity & debt) with comparable degrees of risk. Capital Structure - The firm’s mix of long term debt and equity financing.

2. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 2 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?

3. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 3 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. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 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? Interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2% (i.e. 8 % x.65).

5. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 5 WACC Weighted Average Cost of Capital (WACC) - The expected rate of return on a portfolio of all the firm’s equity and debt (measured by market values). Company cost of capital = Weighted average of debt and equity returns.

6. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 6 WACC

7. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 7 WACC  Taxes are an important consideration in the company cost of capital because interest payments are deducted from income before tax is calculated.

8. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 8 WACC Weighted -average cost of capital=

9. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 9 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 of these required returns.

10. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 10 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.

11. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 11 WACC Example - continued Step 1 Firm Value = 4 + 2 + 6 = $12 mil Step 2 Required returns are given Step 3

12. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 12 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  Beta of assets does not change with capital structure  Beta of equity does change with capital structure  Corporate taxes complicate the analysis and may change our decision

13. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 13 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.

14. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 14 Measuring Capital Structure Market Value of Bonds - PV of all coupons and par value discounted at the yield to maturity (the current interest rate).

15. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 15 Measuring Capital Structure Market Value of Bonds - PV of all coupons and par value discounted at the current interest rate. Market Value of Equity - Market price per share multiplied by the number of outstanding shares.

16. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 16 Measuring Capital Structure

17. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 17 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?

18. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 18 Measuring Capital Structure If the stock is selling for $12 and there are 100 million shares outstanding, then the market value of the stock can be calculated: Market value of stock = No. of shares x price = 100 x 12 = 1,200 Notice this is 3 times greater than the book value of the stock (=100+300 = 400), which will have a big impact on the equity/value ratio

19. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 19 Measuring Capital Structure

20. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 20 Required Rates of Return Bonds Common Stock: Best method is CAPM Where do we find required rates of return?

21. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 21 Required Rates of Return Other ways to find return on equity: Dividend Discount Model Cost of Equity Perpetuity Growth Model = solve for r e

22. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 22 Required Rates of Return Estimating Expected Return on Preferred Stock Price of Preferred Stock = solve for preferred

23. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 23 Results of WACC  WACC of big oil:  WACC = (D/V) x (1-T) x r debt + (E/V) x r equity  WACC =.243 x (1-.35)x.09 +.757 x.12  WACC =.105 or 10.5% (Note: Compare this with the WACC using book values = 8.5% because debt is proportionately larger on the balance sheet)

24. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 24 Uses for WACC  Capital Budgeting (i.e., NPV analysis)  But be careful about assumptions (risk of assets is key, not the way assets are financed)  Valuing a business  If you are buying whole business, then WACC is appropriate to discount cash flows  Make sure you use Free Cash Flows

25. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 25 Capital Budgeting & WACC  WACC is usually not the best answer for the discount rate in capital budgeting (NPV analysis)  The best answer is to find the opportunity cost of equity capital using B assets and CAPM  One problem with WACC is that the appropriate discount rate depends on the risk of project itself, not the overall cost of capital  The other problem with WACC is that it assumes the new project will be financed using the same proportion of debt/equity as the firm

26. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 26 WACC & Capital Budgeting  In capital budgeting, WACC is the best answer when:  the project being evaluated has the same risk as the firm overall; and  The project is being financed with exactly the same proportions of debt and equity as the firm.

27. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 27 Valuing a business: FCF and PV  In valuing a business, WACC is appropriate because it is the after tax cost of financing all the firms activities (this is the primary use of WACC)  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.

28. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 28 Valuing a Business  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. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 29 Valuing a Business  Valuing a Business or Project PV (free cash flows)PV (horizon value)

30. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 12- 30 Valuing a Business Example - Concatenator Manufacturing.