Chapter 13 The Weighted Average Cost of Capital and Company Valuation Fundamentals of Corporate Finance Seventh Edition Richard A. Brealey Stewart C. Myers Alan J. Marcus Chapter 13 The Weighted Average Cost of Capital and Company Valuation Slides by Matthew Will McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved

Topics Covered Geothermal’s Cost of Capital Weighted Average Cost of Capital (WACC) Measuring Capital Structure Calculating Required Rates of Return Calculating WACC Interpreting WACC Valuing Entire Businesses 2

review The three questions of the corporate finance The goal of the corporate finance Straighten out the relationships among risk, return and cost of capital The main concepts : the time value of money, PV and NPV 2

Cost of Capital Cost of Capital - The return the firm’s investors could expect to earn if they invested in securities with comparable degrees of risk. Capital Structure - The firm’s mix of long term financing and equity financing. 3

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? 4

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? 5

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? 6

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? Interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2% (i.e. 8 % x .65). 6

WACC Weighted Average Cost of Capital (WACC) The expected rate of return on a portfolio of all the firm’s securities, adjusted for tax savings due to interest payments. Company cost of capital = Weighted average of debt and equity returns. 7

WACC 10

WACC Taxes are an important consideration in the company cost of capital because interest payments are deducted from income before tax is calculated. 12

WACC Weighted Average Cost of Capital = WACC 13

WACC Three Steps to Calculating Cost of Capital 1. Calculate the value of each security as a proportion of the firm’s market value. 2. Determine the required rate of return on each security. 3. Calculate a weighted average after tax return on the debt and the return on the equity. 11

Weighted Average Cost of Capital with Preferred Stock WACC Weighted Average Cost of Capital with Preferred Stock 13

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. 14

WACC Example - continued Step 1 Firm Value = 4 + 2 + 6 = $12 mil Required returns are given Step 3 17

Measuring Capital Structure In estimating WACC, do not use the Book Value of securities. In estimating WACC, use the Market Value of the securities. Book Values often do not represent the true market value of a firm’s securities. 19

Measuring Capital Structure Market Value of Bonds - PV of all coupons and par value discounted at the current YTM. Market Value of Equity - Market price per share multiplied by the number of outstanding shares. 20

Measuring Capital Structure 21

Measuring Capital Structure If the long term bonds pay an 8% coupon and mature in 12 years, what is their market value assuming a 9% YTM? 21

Measuring Capital Structure 21

Required Rates of Return Bonds Common Stock 23

Required Rates of Return Dividend Discount Model Cost of Equity Perpetuity Growth Model = solve for re 25

Required Rates of Return Expected Return on Preferred Stock Price of Preferred Stock = solve for preferred 27

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

Interpreting WACC The WACC is an appropriate discount rate only for a project that is a carbon copy 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 required increase in return from equity.

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 Betas may change with capital structure Corporate taxes complicate the analysis and may change our decision 18

* FCF and PV * Free Cash Flows (FCF) should be the theoretical basis for all PV calculations. FCF is a more accurate measurement of PV than either Div or EPS. The market price does not always reflect the PV of FCF. When valuing a business for purchase, always use FCF.

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 PVGO.

Capital Budgeting Valuing a Business or Project PV (free cash flows) PV (horizon value)

Capital Budgeting Example - Concatenator Manufacturing

Web Resources www.valuepro.net http://pages.stern.nyu.edu/~adamodar www.ibbotson.com