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The Weighted Average Cost of Capital and Company Valuation: Fundamentals of Corporate Finance

This document discusses the weighted average cost of capital (WACC) and how it is used to value companies. It provides information on calculating WACC, including determining the proportions and required rates of return for a company's debt and equity sources of capital. It also discusses how WACC is interpreted and applied to valuation models using free cash flows. The key steps to calculate WACC are: 1) determine debt to equity proportions, 2) calculate required returns on debt and equity, 3) calculate a weighted average of the costs. WACC represents the average rate of return a company must earn on its portfolio of investments to satisfy its investors.

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72 views30 pages

The Weighted Average Cost of Capital and Company Valuation: Fundamentals of Corporate Finance

This document discusses the weighted average cost of capital (WACC) and how it is used to value companies. It provides information on calculating WACC, including determining the proportions and required rates of return for a company's debt and equity sources of capital. It also discusses how WACC is interpreted and applied to valuation models using free cash flows. The key steps to calculate WACC are: 1) determine debt to equity proportions, 2) calculate required returns on debt and equity, 3) calculate a weighted average of the costs. WACC represents the average rate of return a company must earn on its portfolio of investments to satisfy its investors.

Uploaded by

dewimachfud
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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The Weighted Average Cost of Capital and

Company Valuation
Chapter 13
Fundamentals of Corporate
Finance 2012 Linkpings universitet

Ivar Kreugers (1880-1932) Tndsticks


imperium: debt can be bad.
1917

bildades Finanskoncernen Kreuger

& Toll
Svenska Tndsticks AB, 1930 omfattade
60 % av vrldens tndsticksproduktion.
Kreuger & Toll Pris fll frn sin hgsta
notering i mars 1929 p ver 46 dollar till
4,5 dollar i slutet av 1931
1929 depression, och han fick likviditetskris
Dock hans imperium blev grunden fr
mnga svenska koncernen.

Ivar Kreuger omkring 1930 vid sitt


skrivbord i Tndstickspalatset

Topics
Cost of Capital
Weighted Average Cost of Capital
(WACC)
Measuring Capital Structure
Calculating Required Rates of Return
Calculating WACC
Interpreting WACC
Valuing Entire Businesses

Concept: Cost of Capital


Most companies are financed by a
mixture of securities. Including
common stock, bonds, and other
securities. These securities have
different risks, therefore investors
require different return on them.
Cost of Capital required rate of return
on investment.
It is the return the firms investors could
expect to earn if they invested in other
equally risky securities.
4

Capital Structure
Capital Structure - The firms mix of debt
financing and equity financing.
Long term capital structure involves only long
term debt and equity

Market value of debt and market value


of equity corresponds to the market
capital structure. This is to differentiate
from the book value of debt and equity.
5

WACC

Taxes are an important consideration in


the company cost of capital, because
interest payments are tax deductible.

After tax cost of debt = pretax cost x (1 - tax rate)


= rdebt x (1 - )

WACC
Weighted Average Cost of Capital
(WACC) The expected rate of
return on a portfolio of all the firms
securities, adjusted for tax savings
due to interest payments.
Company cost of capital = Weighted
average of debt and equity returns.

WACC
Weighted Average Cost of Capital =
WACC

D
E

WACC =
(1 - )rdebt +
requity
DE
DE

WACC
Three Steps to Calculating Cost of
Capital
1. Calculate the proportion of firms
debt and equity.
2. Determine the required rate of
return on equity and debt.
3. Calculate a weighted average after
tax return on the debt and equity.
9

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?
Market Value Debt $194
30%

Market Value Equity

$453

70%

Market Value Assets

$647 100%

10

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?

WACC = (.3 8%) + (.7 14%) = 12.2%

11

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?

Portfolio Return = (.3 8%) + (.7 14%) = 12.2%


Interest is tax deductible. Given a 35% tax rate, debt only
costs us 5.2% (i.e. 8 % x .65).

WACC = (.3 5.2%) + (.7 14%) = 11.4%


12

WACC

rassets =

total income
value of investments

rassets

D
V

D rdeb t + E req u ity


D E

1 - rdebt

E
V equity

13

WACC
Weighted Average Cost of Capital with
debt, equity and Preferred Stock
Preferred stock provides a specific
dividend that is paid before any
dividends are paid to common stock.
D
E
P

WACC = (1 - )rdebt + requity + rPreferred


V
V
V

Where D is the value of debt, E is the value of


equity, P is preferred stock, is tax rate.

14

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.

15

WACC
Example - continued
Step 1
Firm Value = 4 + 2 + 6 = $12 mil
Step 2
Required returns are given
Step 3

6
4

0.18
WACC =
(1 - 0.35)0.06 +
0.12 +
12
12

12

= 0.123 or 12.3%

16

Measuring Market Capital


Structure
Market Value of Bonds Present
Value of all coupons and par value
discounted at the current yield to
maturity, YTM.
Market Value of Equity - Market
price per share multiplied by the
number of outstanding shares.

17

Measuring Market Capital


Structure
Page 374/5 Example: Suppose Long term bond
has a coupon payment of 8%, 12 year to maturity.
Common stocks 100 million shares valued at 12 $
each

18

Measuring Market Capital


Structure
If the long term bonds pay an 8% coupon
and mature in 12 years, market interest rate
is 9%, what is the market value of the bonds?
16
16
16
216
PV

....
2
3
12
1.09 1.09 1.09
1.09
$185.70
19

Measuring Capital
Structure

20

Cost of capital is the same as


the Required Rates of Return
On Bonds

rd = YTM

On Common Stock

re = CAPM
= rf + i (rm - rf )
That is, expected return on stock is equal to risk free return plus
beta times market risk premium.
21

Required Rates of Return can


also be obtained from DDM
Dividend Discount Model (DDM)
Constant Dividend Growth Model =

Div1
P0 =
re - g
solve for re

Div1
re =
+ g
P0
22

Required Rates of
Return
Expected Return on Preferred Stock
Price of Preferred Stock =

P0 =
solve for

Div
rpreferred

preferred

rpreferred

Div
=
P0
23

WACC for Selected Firms


Amazon.com
Ford
Newmont Mining
Intel
Microsoft
Dell Computer
Boeing
McDonalds
Pfizer
Dupont
Disney
ExxonMobil
IBM
Wal-Mart
Campbell Soup
GE
Heinz

Expected
return
Interest rate Proportion of Proportion of
on equity (%) on debt (%) Equity (E/V) Debt (D/V) WACC (%) Mkt Cap Totl debt
19.8
7.3
0.96
0.04
19.3
33.8
1.2
20.2
7.7
0.07
0.93
6.1
12.2
163.2
8.9
6.5
0.89
0.11
8.4
24.2
3.0
14.1
5.8
0.98
0.02
13.9
111.2
2.0
10.3
na
1.00
0.00
10.3
311.7
0.0
11.9
6.0
0.99
0.01
11.8
47.8
0.7
11.6
5.8
0.88
0.12
10.7
62.4
8.6
13.1
5.9
0.89
0.11
12.1
62.5
7.8
7.7
5.3
0.95
0.05
7.5
159.3
8.7
11.7
6.0
0.81
0.19
10.2
38.9
9.0
10.0
6.0
0.78
0.22
8.7
55.5
15.5
8.7
5.3
1.00
0.00
8.7
465.0
0.0
10.9
5.8
0.80
0.20
9.5
140.7
35.3
4.7
5.7
0.80
0.20
4.5
190.0
47.4
6.2
6.0
0.82
0.18
5.8
12.6
2.8
8.3
5.3
0.41
0.59
5.4
344.0
491.0
7.1
6.7
0.73
0.27
6.4
14.3
5.3

Notes: 1. Expected return on equity is taken from Table 12-2


2. Interest rate on debt is calculated from yields on similarly rated bonds
3. D is the book value of the firm's debt,and E is the market value of
equity
4. WACC = (1 - .35) x rdebt x (D/V) + requity x (E/V)
24

Interpreting WACC
The

WACC is an appropriate discount


rate only for a project that is the same of
the firm's existing business
There are two costs of debt financing.
The explicit cost of debt is the rate of
interest bondholders demand. The
implicit cost is the increased required
return from equity due to increased
bankruptcy probability.
25

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 of bankruptcy
Betas may change
D with capital structure
E

assets = V 1 - debt + V equity

Corporate taxes complicate the analysis and may change


our decision
26

FCF and PV
Free

Cash flow is cash flow that is available


to investors,
FCF= operating cash flow - investment
expenditures.
FCF is a more accurate measurement of PV
than either Dividend or Earnings per share
EPS.
Free Cash Flows (FCF) should be the
theoretical basis for all PV calculations.
When valuing a business for purchase,
always use FCF.
27

Capital Budgeting
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 present value of growth
opportunity (PVGO).

FCF1
FCF2
FCFH
PVH
PV

...

1
2
H
(1 WACC ) (1 WACC )
(1 WACC )
(1 WACC ) H

28

Capital Budgeting
Valuing
PV

a Business or Project

FCF1
FCF2
FCFH
PVH

...

(1 WACC )1 (1 WACC ) 2
(1 WACC ) H (1 WACC ) H

PV (free cash flows)

PV (horizon value)

29

Capital Budgeting
See P 382/3, Example - Concatenator
Manufacturing, cash flows are
provided as follows: y1=-73,6 y2=-87,1
y3=-102,9 Y4=-34,1 y5=40,2 y6=79,5
with a discount rate 8,5%, and a steady growth of 5%
from year 5 onwards.

79.5
Horizon Value
2,271.40
.085 .05
73.6
87.1
102.9
34.1
40.2
2,271.40

1.085 1.085 2 1.085 3 1.085 4 1.085 5 1.085 5


1,290.40

PV(FCF) -

30

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