1. The Weighted Average Cost of Capital and Company Valuation
Chapter 13
Fundamentals of Corporate Finance 2012 Linköpings universitet

2. Ivar Kreugers (1880-1932) Tändsticks imperium: debt can be bad.
1917 bildades Finanskoncernen Kreuger & Toll
Svenska Tändsticks AB, 1930 omfattade 60 % av världens tändsticksproduktion.
Kreuger & Toll Pris föll från sin högsta notering i mars 1929 på över 46 dollar till 4,5 dollar i slutet av 1931
1929 depression, och han fick likviditetskris
Dock hans imperium blev grunden för många svenska koncernen.
Ivar Kreuger omkring 1930 vid sitt skrivbord i Tändstickspalatset

3. 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 2

4. 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 firm’s investors could expect to earn if they invested in other equally risky securities. 3

5. Capital Structure
Capital Structure - The firm’s 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.

6. WACC
Taxes are an important consideration in the company cost of capital, because interest payments are tax deductible. 12

7. 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

8. WACC
Weighted Average Cost of Capital = WACC 13

9. WACC
Three Steps to Calculating Cost of Capital 1. Calculate the proportion of firm´s 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. 11

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? 5

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? 6

12. 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

13. WACC 10

14. 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.
Where D is the value of debt, E is the value of equity, P is preferred stock, τ is tax rate. 13

15. 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

16. WACC
Example - continued Step 1 Firm Value = = $12 mil Step 2 Required returns are given Step 3 17

17. 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. 20

18. 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 21

19. 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? 21

20. Measuring Capital Structure21

21. Cost of capital is the same as the Required Rates of Return
On Bonds
On Common Stock
That is, expected return on stock is equal to risk free return plus beta times market risk premium. 23

22. Required Rates of Return can also be obtained from DDM
Dividend Discount Model (DDM)
Constant Dividend Growth Model =
solve for re 25

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

24. 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 = ( ) x rdebt x (D/V) + requity x (E/V)

25. 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.

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

27. 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.

28. 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).

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

30. 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.