# Things to Absorb, Read, and Do

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1 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. McGraw-Hill/Irwin Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved. 3-2 Contact Information Professor: Charles Hodges Webpage: D2L Phone: (678) , (770) D2L and Office: Not Applicable Office Hours:Not Applicable 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

2 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 WACC relation to risk Assets = Liabilities + Equity Implies Return on (Assets) = Return on (Liabilities + Equity) Risk (Assets) = Risk (Liabilities + Equity) 14-5 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. If the firm issues preferred stock:

3 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 = R D (1-T C ) Dividends are not tax deductible, so there is no tax impact on the cost of equity WACC = w E R E + w D R D (1-T C ) 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) , (770) D2L and Office: Not Applicable Office Hours:Not Applicable

4 Company Cost of Capital The company cost of capital is a weighted average of returns demanded by debt and equity investors. Calculating WACC If there are 3 (or more) sources of financing, simply calculate the weighted-average after-tax return of each 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?

5 Weighted Average Cost of Capital For proper valuation we must value the firm s after-tax cash flows. Weighted Average Cost of Capital The WACC provides a firm s after-tax cost of capital. Why is it important to account for taxes? Where: T c = The firm s average tax rate 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. 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%?

6 Calculating WACC If there are 3 (or more) sources of financing, simply calculate the weighted-average after-tax return of each security type. If the firm issues preferred stock: 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 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 shares outstanding

7 Contact Information Professor: Charles Hodges Webpage: D2L Phone: (678) , (770) D2L and Office: Not Applicable Office Hours:Not Applicable 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 3-25 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. 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

8 Expected Return on Bonds Cost of Debt The risk of bankruptcy aside, the yield to maturity represents an investor s expected return on a firm s bonds Expected Return on Common Stock Estimating r equity using CAPM: Expected Return on Common Stock Estimating r equity using the DDM: 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? 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?

9 Cost of Equity Expected Return on Preferred Stock A preferred stock that pays a fixed annual dividend is no more than a simple perpetuity 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) , (770) D2L and Office: Not Applicable Office Hours:Not Applicable

10 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 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

11 Risk Level Example: Subjective Approach Discount Rate Very Low Risk WACC 8% Low Risk WACC 3% Same Risk as Firm WACC High Risk WACC + 5% 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 Very High Risk WACC + 10% 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%. Valuing Entire Businesses We can treat entire companies like giant projects and value them using the WACC. 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? Free Cash Flow Cash flow that is not required for investment in fixed assets or working capital and is therefore available to investors

12 Valuing Entire Businesses 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 Valuing Entire Businesses: Example Contact Information Professor: Charles Hodges Webpage: D2L Phone: (678) , (770) D2L and Office: Not Applicable Office Hours:Not Applicable

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