Things to Absorb, Read, and Do

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Things to Absorb, Read, and Do

 Things to absorb - Everything, plus remember some material from previous chapters. This chapter applies Chapter’s 6, 7, and 12, Risk and Return concepts to the market value Balance Sheet of Corporations. The basic task is to calculate the return on a portfolio, where the portfolio consists of the securities issued by a single company (i.e., their long term debt and equity aka., equation 13-1a on page 378). You should be able to convert a book value balance sheet to a market value balance sheet.

 Things to Read - Read Chapter 13, and be prepared to re-read parts of Chapter 3, 6, 7, and 12.

 Things to Do - Make 100 on the quiz. There are only 19 End of Chapter Questions, be able to answer all of them.

3-2

Contact Information

 Professor:

Charles Hodges

 Webpage: D2L

 Phone: (678) 839-4816, (770)301-8648

 Email: D2L and [email protected]

 Office: Not Applicable

 Office Hours:Not Applicable

3-3 13-4

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.

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Why Cost of Capital Is Important

 We know that the return earned on assets depends on the risk of those assets

 The return to an investor is the same as the cost to the company

 Our cost of capital provides us with an indication of how the market views the risk of our assets

 Knowing our cost of capital can also help us determine our required return for capital budgeting projects

14-5

WACC relation to risk

 Assets = Liabilities + Equity

 Implies

Return on (Assets) = Return on (Liabilities + Equity)



Risk (Assets) = Risk (Liabilities + Equity)

The Weighted Average Cost of

Capital

 We can use the individual costs of capital that we have computed to get our “average” cost of capital for the firm.

 This “average” is the required return on the firm’s assets, based on the market’s perception of the risk of those assets

 The weights are determined by how much of each type of financing is used

Calculating WACC

If there are 3 (or more) sources of financing, simply calculate the weighted-average after-tax return of each

security type.

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13-9

Cost of Capital Estimation Worksheet WACC = wd* rd * (1-t) + ws re

wd = Percent of Debt = Low estimate ___________ High estimate _____________ rd = Yield to Maturity on Debt = Low estimate _________ High estimate _________ t = Tax Rate = Best Guess ____________________

ws = Percent of Equity = Low estimate ___________ High estimate ____________ (note, ws + wd = 100%

re1 = required return on stock using Dividend Growth Model d1 = Stock Price =

Growth rate = Low estimate ___________ High estimate ____________ d1/p0+ g = Low estimate ___________ High estimate ____________ re2 = required return on stock using Capital Asset Pricing Model krf = _________________ Market Risk Premium = ______________ Beta = Low estimate ___________ High estimate ____________ krf + B *(MRP) = Low estimate ___________ High estimate ____________ re3 = required return on stock using Bond Yield + 4% = ______________ Overall estimate for required return on stock =

Low estimate ___________ High estimate ____________

Low Estimate WACC = _______= wd______* rd ______* (1-t______) + ws______ re________ High Estimate WACC = _______= wd______* rd ______* (1-t______) + ws______ re________ Best Estimate WACC = _______= wd______* rd ______* (1-t______) + ws______ re________

Taxes and the WACC

 We are concerned with after-tax cash flows, so we also need to consider the effect of taxes on the various costs of capital  Interest expense reduces our tax liability

 This reduction in taxes reduces our cost of debt

 After-tax cost of debt = RD(1-TC)

 Dividends are not tax deductible, so there is no tax impact on the cost of equity

 WACC = wERE+ wDRD(1-TC)

14-10

13-11

Company Cost of Capital

 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.

Contact Information

 Professor:

Charles Hodges

 Webpage: D2L

 Phone: (678) 839-4816, (770)301-8648

 Email: D2L and [email protected]

 Office: Not Applicable

 Office Hours:Not Applicable

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13-13

Company Cost of Capital

The company cost of capital is a weighted average of returns demanded by debt and equity investors.

13-14

Calculating WACC

security type.

 If the firm issues preferred stock:

Computing WACC

 WACC = w

E

R

E

+ w

P

R

P

+w

D

R

D

(1-T

C

)

 w

E

= $E/($E+$P+$D), or will be given

w_P=$P/($E+$P+$D)

w_D=$D/($E+$P+$D)

 R

E

= Rf + B(MRP) = Rf + B (Rm-Rf) = D1/P0

+ g = (D0(1+g))/P0 + g

 R

P

= Dividend/ Price

 R

D

= Yield to maturity on debt

 T

C

, will be given

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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13-17

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?

13-18

Weighted Average Cost of Capital

The WACC provides a firm’s after-tax cost of

capital.

Where:

Tc = The firm’s average tax rate

13-19

Calculating WACC

 A firm’s WACC is calculated in 3 steps:

1. Calculate the value of each security as a proportion

of firm value.

2. Determine the required rate of return on each security.

3. Calculate a weighted average of the after-tax return on the debt and return on the equity.

13-20

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.

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13-21

Calculating WACC

security type.

 If the firm issues preferred stock:

13-22

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.

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? • We invested in a project offering a 10% return? • We invested in a project offering a 9.7% return?

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

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Contact Information

 Professor:

Charles Hodges

 Webpage: D2L

 Phone: (678) 839-4816, (770)301-8648

 Email: D2L and [email protected]

 Office: Not Applicable

 Office Hours:Not Applicable

3-25

Computing WACC

 WACC = w

E

R

E

+ w

P

R

P

+w

D

R

D

(1-T

C

)

 w

E

= $E/($E+$P+$D), or will be given

w_P=$P/($E+$P+$D)

wD=$D/($E+$P+$D)

 R

E

= Rf + B(MRP) = Rf + B (Rm-Rf) = D1/P0

+ g = (D0(1+g))/P0 + g

 R

P

= Dividend/ Price

 R

D

= Yield to maturity on debt

 T

C

, will be given

13-27

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.

13-28

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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13-29

Expected Return on Bonds

The risk of bankruptcy aside, the yield to

maturity represents an investor’s expected

return on a firm’s bonds.

Cost of Debt

14-30

Expected Return on Common

Stock

 Estimating r

equity

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?

Expected Return on Common

Stock

 Estimating r

equity

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?

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Cost of Equity

14-33

13-34

Expected Return on Preferred

Stock

A preferred stock that pays a fixed annual

dividend is no more than a simple perpetuity.

13-35

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?

Contact Information

 Professor:

Charles Hodges

 Webpage: D2L

 Phone: (678) 839-4816, (770)301-8648

 Email: D2L and [email protected]

 Office: Not Applicable

 Office Hours:Not Applicable

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13-37

WACC Pitfalls

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

Divisional and Project Costs of

Capital

 Using the WACC as our discount rate is only appropriate for projects that have the same risk as the firm’s current operations

 If we are looking at a project that does NOT have the same risk as the firm, then we need to determine the appropriate discount rate for that project  Divisions also often require separate

discount rates

14-38

The Pure Play Approach

 Find one or more companies that specialize in the product or service that we are considering  Compute the beta for each company  Take an average

 Use that beta along with the CAPM to find the appropriate return for a project of that risk  Often difficult to find pure play companies

Subjective Approach

 Consider the project’s risk relative to the firm overall

 If the project has more risk than the firm, use a discount rate greater than the WACC

 If the project has less risk than the firm, use a discount rate less than the WACC

 You may still accept projects that you shouldn’t and reject projects you should accept, but your error rate should be lower than not considering differential risk at all

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Example: Subjective

Approach

Risk Level Discount Rate

Very Low Risk WACC – 8%

Low Risk WACC – 3%

Same Risk as Firm WACC

High Risk WACC + 5%

Very High Risk WACC + 10%

14-41

Flotation Costs

 The required return depends on the risk, not how the money is raised

 However, the cost of issuing new securities should not just be ignored either

 Basic Approach

 Compute the weighted average flotation cost

 Use the target weights because the firm will issue securities in these percentages over the long term

14-42

13-43

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?

13-44

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

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13-45

Valuing Entire Businesses

13-46

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