CHAPTER 13: RISK, COST OF CAPITAL, AND VALUATION

The goal of this chapter is to determine the rate at which cash flows of risky projects and firms
are to be discounted.

1. Estimating the cost of equity capital with the CAPM

Under the CAPM, the expected return
Cost of equity:

● The risk-free rate, RF .

● The market risk premium, RM 2 RF .
● The stock beta, b.

2. Cost of fixed income securities

● Cost of equity
We will use CAPM model to calculate the cost of equity of an security:

Example: The Dybvig Corporation’s common stock has a beta of 1.17. If the risk-free rate is 3.8
percent and the expected return on the market is 11 percent, what is Dybvig’s cost of equity
capital?
R = .1222, or 12.22%

● Cost of debt (calculate r): using bond price formula

Aftertax cost of debt = (1 - Tax rate) x r

+ What are bond’s components ?
1. Coupons (C): regular interest payments, constant and paid every year.
2. Face value/par value (F): the amount repaid at the end of the loan is called a
level coupon bond

💡
● Typically, face value = $1,000
Tips:if the face value is not given in the exercise, we take face value equal
$1,000)
3. Maturity (n): the number of years until the face value is paid
4. Yield to maturity (YTM)/bond’s yield:
● interest rates change in the marketplace. However, the cash flows from a
bond stay the same, the value of the bond fluctuates.
 ● When the interest rate increases, the present value of the bond's
remaining cash flows decreases and when interest rates fall, the bond is
worth more.
● The interest rate required in the market on a bond is called the bond’s
yield to maturity (YTM)

Example 1:
Shanken Corp. issued 5.9 percent coupon rate semiannual bond within 6 years. The bond
currently sells for 108 percent of its face value. The company’s tax rate is 35 percent.
a. What is the pretax cost of debt?
b. What is the aftertax cost of debt?
a. 1080 = (1000*5.9%/r)*(1-1/(1+r/2)^12) + 1000/(1+R/2)^12 => R = 4.37%
b. After tax cost of debt = 4.37%*(1-0.35) = 2.84%

Example 2
Valuing Bonds Microhard has issued a bond with the following characteristics:
Par: $1,000
Time to maturity: 20 years
Coupon rate: 7 percent
Semiannual payments
Calculate the price of this bond if the bond price is:
a. $1,000 => YTM = 7%
b. $815.98 => YTM = 9%
c. $1,251=> YTM = 5%

● Cost of preferred stock

Preferred stock is probably more similar to bonds than common stock. Preferred stock pays a
constant dividend in perpetuity.

Example: Suppose a share of the preferred stock of Polytech, Inc., is selling at $17.16 and pays
a dividend of $1.50 per year. What is the cost of this preferred stock ?
Ans: Rp = 1.5/17.16 = 8.74%

8. THE WEIGHTED AVERAGE COST OF CAPITAL(WACC)

The WACC is the minimum return a company needs to earn to satisfy all of its investors,
including stockholders, bondholders, and preferred stockholders.

S: value of stock Rs: stock’s required return Tc: tax

B: value of bonds Rb: bond’s required return
Example:
Consider a firm whose debt has a market value of $40 million and whose stock has a market
value of $60 million (3 million outstanding shares of stock, each selling for $20 per share). The
firm pays a 5 percent rate of interest on its new debt and has a beta of 1.41. The corporate tax
rate is 34 percent. Risk premium on the market is 9.5 percent and the current Treasury bill rate
is 1 percent. What is this firm’s WACC?

Step 1: calculate the cost of equity:

Rs = Rf + β x (Rm - Rf) = 1% + 1.41*9.5% = 14.395%

Step 2: calculate cost of debt after tax:

Rb (after tax) = 5% * (1-0.34) = 3.3%

Step 3: calculate proportion of debt and equity:

Total value: $100 million (market debt value = 40%, market stock value = 60%)

Step 4: Calculate the WACC

WACC = = 0.6*14.4+0.4*5%*(1-0.34) =
9.96%

9. Valuation with Rwacc

● Project valuation
When valuing a project we start by determining the correct discount rate and use
discounted cash flows to determine NPV.

🔹Suppose a firm has both a current and a target debt–equity ratio of .6, a cost of debt of 5.15
percent, and a cost of equity of 10 percent. The corporate tax rate is 34 percent. What is the
firm’s weighted average cost of capital?

First step is to transform the debt-equity (B/S) to debt-total asset ratio.

Equity + Debt = Asset
Debt/equity = 0.6 => Debt/(asset - debt) = 0.6 => Debt = 0.6Asset - 0.6Debt
=> 1.6 Debt = 0.6Asset => Debt/Asset = 0.6/1.6 = 0.375 => Equity/Asset = 1-0.375 = 0.625
🔹Suppose the firm is considering taking on a warehouse renovation costing $60 million that is
expected to yield after tax cost savings of $12 million a year for six years. What is the NPV with
WACC discount rate ?

● Firm valuation with the Rwacc

When valuing a complete business enterprise our approach is the same as the one used for
individual capital projects like the warehouse renovation, except that we use a horizon, and this
complicates the calculations.

let’s take an example:

Consider the Good Food Corporation, a public company headquartered in Barstow, California,
that is currently a leading global food service retailer. It operates about 10,000 restaurants in
100 countries. Good Food serves a value-based menu focused on hamburgers and french fries.
The company has $4 billion in market valued debt and $2 billion in market valued common
stock. Its tax rate is 20 percent. Good Food has estimated its cost of debt as 5 percent and its
cost of equity as 10 percent.
=> WACC = ?
Good Food to buy Happy Meals. If Happy Meals analysts estimate the net cash flows from
Happy Meals would be:

● Calculating the terminal value of Happy Meals, g=2%:

● Compute the present value of Happy Meals:

● Given that Happy Meals have $1,318.8 debt outstanding.

=> Find the value of equity = $1,978.2 2 - $1,318.8 5 = $659.4 (million)
=> Given that we have 12.5 million shares outstanding. Equity value per share =
$659.4/12.5 = $52.8
 Exercise

1. Calculating WACC Mullineaux Corporation has a target capital structure of 70

percent common stock and 30 percent debt. Its cost of equity is 11.5 percent, and the
cost of debt is 5.9 percent. The relevant tax rate is 35 percent. What is the company’s
WACC?

2. Finding the Capital Structure Fama’s Llamas has a weighted average cost of capital
of 9.8 percent. The company’s cost of equity is 13 percent, and its cost of debt is 6.5
percent. The tax rate is 35 percent. What is Fama’s debt–equity ratio?
9.8%=(1-X)*13% + X*6.5%*(1-0.35) =>X = 36.46%(debt/asset ratio)
Equity/asset ratio = 1-36.46% = 63.54%
=> Debt - equity ratio = 36.46%/63.54% = 57.46%

3. Book Value versus Market Value Filer Manufacturing has 8.3 million shares of
common stock outstanding. The current share price is $53, and the book value per share
is $4. The company also has two bond issues outstanding. The first bond issue has a
face value of $70 million and a coupon rate of 7 percent and sells for 108.3 percent of
par. The second issue has a face value of $60 million and a coupon rate of 7.5 percent
and sells for 108.9 percent of par. The first issue matures in 8 years, the second in 27
years.
a. What are the company’s capital structure weights on a book value basis?
b. What are the company’s capital structure weights on a market value basis?
4. Finding the WACC Given the following information for Huntington Power Co., find the
WACC. Assume the company’s tax rate is 35 percent.

Debt: 10,000 5.6 percent coupon bonds outstanding, $1,000 par value, 25 years
to maturity, selling for 97 percent of par; the bonds make semiannual payments.
Common stock: 425,000 shares outstanding, selling for $61 per share; the beta
is .95.
Market: 7 percent market risk premium and 3.8 percent risk-free rate.

Cost of equity = 10.45%

Cost of debt = 5.83% => after tax = 5.83*(1-35%)= 3.79%
⇔ 970 = 1000*2.8*(1-(1+r/2)^-50)/r/2 + 1000/(1+r/2)^50 =>
Total value = equity value + debt value = $35,625,000
Debt/asset = 9,700,000/35,625,000 = 27.22% => Wd =
Equity/asset = 425,000*61/35,625,000 = 72.77% => We =
WACC = 0.27*3.79%+0.73*10.45% = 8.65%
5. Preferred Stock and WACC The Saunders Investment Bank has the following financing
outstanding. What is the WACC for the company?
● Debt: 50,000 bonds with a coupon rate of 5.7 percent and a current price quote of 106.5;
the bonds have 20 years to maturity. 200,000 zero coupon bonds with a price quote of
17.5 and 30 years until maturity.
● Preferred stock: 125,000 shares of 4 percent preferred stock with a current price of
$79, and a par value of $100.
● Common stock: 2,300,000 shares of common stock; the current price is $65, and the
beta of the stock is 1.20.
● Market: The corporate tax rate is 40 percent, the market risk premium is 7 percent, and
the risk-free rate is 4 percent.

Zero coupon
17.5%*1,000 = 1,000/(1+r/2)^60 => R(zero coupon) = 5.89%
Bonds with a coupon rate of 5.7%

Cost Value Weight

Equity 12.4% $149,500,000 60.38%

Debt Cost of debt1: Zero coupon = Zero coupon =

(Zero coupon): $35,000,000 14.13%
1000/(1+R/2)^60 Coupon rate= Coupon rate =
=> R = 5.9% $53,250,000 21.5%

Cost of debt2
(Coupon rate) = 5.17%

Preferred stock 5.06% $9,875.000 3.99%

Total value =
$247,625,000

WACC = 60.38%*12.4% + 21.5%*5.17%*(1-40%) +

5.9%*14.13%*(1-40%)+3.99%*5.06%=8.86%