Chapter 2
Chapter 2
Assume DuPont’s class A preferred stock has a price of $85.83 and an annual dividend of
$3.50. Its cost of preferred stock, therefore, is $3.50 ÷ $85.83 = 4.08%
WACC Equation
rwacc = rEE% + rpfd P% + rD(1 TC)D%
For a company that does not have preferred stock, the WACC condenses to:
rwacc = rEE% + rD(1 TC)D%
Methods in Practice
Net Debt
Net Debt = Debt – Cash and Risk-Free Securities
Levered Value
The value of an investment, including the benefit of the interest tax
deduction, given the firm’s leverage policy
WACC Valuation Method -> levered value
Discounting future incremental free cash flows using the firm’s WACC, which
produces the levered value of a project:
Key Assumptions
Average Risk
We assume initially that the market risk of the project is equivalent to the average
market risk of the firm’s investments
Constant Debt-Equity Ratio
We assume that the firm adjusts its leverage continuously to maintain a constant
ratio of the market value of debt to the market value of equity
Limited Leverage Effects
We assume initially that the main effect of leverage on valuation follows from the
interest tax deduction and that any other factors are not significant at the level of
debt chosen
Assumptions in Practice
These assumptions are reasonable for many projects and firms
The first assumption is likely to fit typical projects of firms with
investments concentrated in a single industry
The second assumption reflects the fact that firms tend to increase their
levels of debt as they grow larger
The third assumption is especially relevant for firms without very high
levels of debt where the interest tax deduction is likely to be the most
important factor affecting the capital budgeting decision
Summary of WACC Method
1. Determine the incremental free cash flow of the investment
2. Compute the weighted average cost of capital
3. Compute the value of the investment, including the tax benefit of leverage,
by discounting the incremental free cash flow of the investment using the
WACC
Issuing costs should be treated as cash outflows that are necessary to the project.
They can be incorporated as additional costs (negative cash flows) in the NPV analysis.
APV:
The adjusted present value is the net present value (NPV) of a project or company if
financed solely by equity plus the present value (PV) of any financing benefits,