FINA 4330 The Weighted Average Cost of Capital Lecture 21 Fall, 2010 Corporate Finance FINA 4330 The Weighted Average Cost of Capital Lecture 21 Fall, 2010

Cost of Capital rs = ro + (ro -rB)B/S WACC = ro r rB

Cost of Capital (After Tax) rs = ro + (ro-rB)(1-T)B/S r WACC = r0(1-T(D/v)) = rs(S/V) + rB(1-T) (B/V) rB

The two ways of representing firm value V = V (u) + T The two ways of representing firm value V = V (u) + T * B V = SY(1-T) (1+WACC)t Where, WACC = r0 = rs (S/V) + rB (1-T)(B/V)

Static Tradeoff Theorem Costs of Financial Distress (“Contracting Costs”) Potential Bankruptcy Costs Underinvestment Risk Shifting Agency Costs Assume: Not Taxes Risk neutrality Single period Interest rate = 0%

Example of Underinvestment ASSETS PVA $1,000,000 PVGO 2,000,000 TOTAL $3,000,000 LIABILITIES DEBT 2,500,000 EQUITY 500,000 TOTAL $3,000,000

Example of Underinvestment ASSETS PVA $1,000,000 PVGO 2,000,000 TOTAL $3,000,000 LIABILITIES DEBT 2,500,000 EQUITY 500,000 TOTAL $3,000,000

Example of Underinvestment ASSETS PVA $1,000,000 (Cash = 600,000) (Real Assets = 400,000) PVGO 2,000,000 TOTAL $3,000,000 LIABILITIES DEBT 2,500,000 EQUITY 500,000 TOTAL $3,000,000

Example of Underinvestment Make a Div Payment rather than invest ASSETS PVA $400,000 (Real Assets = 400,000) PVGO 2,000,000 TOTAL $2,400,000 LIABILITIES DEBT 2,250,000 EQUITY 1 50,000 TOTAL $2,400,000

Risk Shifting Suppose the firm has value that will look like the following: Value in Good State = $4,500,000 Value in Bad State = 1,500,000 With equal probability Promised payment to the Bondholder: $3,500,000 What is the value of the equity and the debt?

Investment Opportunity Invest $1,000,000 to generate: $1,500,000 with probability ½ in good state, 0 otherwise, so that New cash flows are: $5,000,000 in good state 500,000 in bad state: What is the NPV of the project, value of the debt and value of the equity?

Firm Value Costs of Financial Distress V = V(u) + PV of Tax Shield Debt Level Optimal Debt Level

Pecking Order Hypothesis Costly Information Conclusion Firm has an ordering under which they will Finance First, use internal funds Next least risky security

Intuition Suppose that you know your firm is undervalued, and you want to invest in a project: How do you finance it? Now suppose you believe the firm is overvalued

Pecking Order theory So you have a dominating way of getting capital Internal Financing Risk free debt Risky debt Equity In general, the more “debt like” a security is, the more you want to issue it.

So the announcement effect If the firm announces it intends to issue equity to invest in a project, this is bad news and stock prices will go down. That is the market will ASSUME this is a bad firm. Therefore the firm will never issue equity if it can avoid it. Thus pecking order.