1. 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

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

3. 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

4. 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)

5. 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%

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

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

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

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

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

11. 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?

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

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

14. 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

15. 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.

16. 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.