FIN303 Vicentiu Covrig 1 Cost of Capital (chapter 10)

FIN303 Vicentiu Covrig 2 What sources of long-term capital do firms use? Long-Term Capital Long-Term Debt Preferred Stock Common Stock Retained Earnings New Common Stock

FIN303 Vicentiu Covrig 3 Calculating the weighted average cost of capital WACC = w d r d (1-T) + w p r p + w c r s The w’s refer to the firm’s capital structure weights. d: debt; p: preferred; c: common equity T: tax rate The r’s refer to the cost of each component. We will ignore the preferred stock. You DON’T have to prepare preferred stock for the Final exam. WACC = w d r d (1-T) + w c r s without prefer stock Ex. Capital structure of a firm might be 300m. in debt and 700m. in common stock. Calculate the weight of each security. w d = 0.3; and w c = 0.7

FIN303 Vicentiu Covrig 4 Component cost of debt WACC = w d r d (1-T) + w c r s r d is the marginal cost of debt capital. The yield to maturity on outstanding long-term debt is often used as a measure of k d. Why tax-adjust, i.e. why r d (1-T)?

FIN303 Vicentiu Covrig 5 A 15-year, 12% semiannual coupon bond sells for $1, What is the cost of debt (r d )? Remember, the bond pays a semiannual coupon, so r d = 5.0% x 2 = 10%. INPUTS OUTPUT NI/YRPMTPVFV

FIN303 Vicentiu Covrig 6 Component cost of equity WACC = w d r d (1-T) + w c r s r s is the cost of common equity CAPM: k s = k RF + (k M – k RF ) β If the k RF = 7%, RP M = 6%, and the firm’s beta is 1.2, what’s the cost of common equity based upon the CAPM? 14.2% DCF:k s = D 1 / P 0 + g [ This formula above is a rearrangement of ] If D 0 = $4.19, P 0 = $50, and g = 5%, what’s the cost of common equity based upon the DCF approach? 13.8%

FIN303 Vicentiu Covrig 7 What is the firm’s WACC? Tax rate = 40% WACC= w d k d (1-T) + w p k p + w c k s = 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%) = 1.8% + 0.9% + 8.4% = 11.1%

FIN303 Vicentiu Covrig 8 What factors influence a company’s composite WACC? Market conditions. The firm’s capital structure and dividend policy. The firm’s investment policy. Firms with riskier projects generally have a higher WACC.

FIN303 Vicentiu Covrig 9 Should the company use the composite WACC as the hurdle rate for each of its projects? NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the “hurdle rate” for a typical project with average risk. Different projects have different risks. The project’s WACC should be adjusted to reflect the project’s risk.

FIN303 Vicentiu Covrig 10 Exam type question Wyden Brothers has no retained earnings. The company uses the CAPM to calculate the cost of equity capital. The company’s capital structure consists of common stock and debt. Which of the following events will reduce the company’s WACC? a.A reduction in the market risk premium. * b.An increase in the company’s credit risk. c.An increase in the company’s beta. d.An increase in expected inflation.

FIN303 Vicentiu Covrig 11 Exam type question Billick Brothers is estimating its WACC. The company has collected the following information: Its capital structure consists of 40 percent debt and 60 percent common equity. The company has 20-year bonds outstanding with a 9 percent annual coupon that are trading at par. The company’s tax rate is 40 percent. The risk-free rate is 5.5 percent. The market risk premium is 5 percent. The stock’s beta is 1.4. What is the company’s WACC? a. 9.71% b. 9.66% * c. 8.31% d.11.18%

FIN303 Vicentiu Covrig 12 Learning objectives Know how to calculate the WACC based on the equity and debt components Discuss several factors that can affect the composite cost of capital (see slide 8) Cost of preferred (section 10.4), and sections 10.6, 10.9 and will NOT be on the exam Recommended end-of-chapter problems: 10-1,10-3, 10-4 (without floatation), 10-8