1. 1 COST OF CAPITAL WEIGHTED AVG COST OF CAPITAL (WACC) r = w d r d + w e r e w d = proportion of assets funded by debt r d = After-tax cost of debt w e = proportion of assets funded by equity r e = cost of equity

2. 2 COST OF CAPITAL r d = 10% r p = 15% r e = 18% w d = 40% w p = 10% w e = 50% Proof: Firm raises $100 -- Buys an Asset Asset earns $14.50: Debt: $40 @ 10% =$ 4.00 Prefs: $10 @ 15% =$ 1.50 Equity: $50 @ 18%=$ 9.00 Total $14.50 WACC= 40(.10)+10(.15)+50(.18) = 4 + 1.50 + 9 = 14.50%

3. 3 COST OF CAPITAL WEIGHTS: BOOK VALUE MARKET VALUE TARGET COSTS: HISTORIC CURRENT (MARGINAL)

4. 4 COST OF CAPITAL ESTIMATING COSTS DEBT:BANK RATE YIELD TO MATURITY ON BONDS Find the IRR on the bond: PV=Price FV = 1000 Payment = Coupon/2 N = #years * 2 Return you get (irr) is a six month return Yield to maturity = r d = 2*irr Note: Strictly, r d = (1+irr) 2 - 1

5. 5 COST OF EQUITY Constant Growth Model: r e = DY + CGY DY = Dividend Yield CGY = Capital gains Yield (Growth) Capital Asset Pricing Model r e = r f +  (Mkt Premium) r f = Risk Free Rate  = Relative Riskiness of Firm Mkt Prem =Risk Premium Paid on Average Company = r mkt - r f

6. 6 Example: Kelloggs

7. 7 Kellogg’s Costs Debt:Bank Rate: 8.0% r d = 8.0 * (1-0.34) = 5.28% Equity: CGM: r e = DY + CGY = 0.90(1.08)/39 +.08 =.025 +.08 = 10.5% CAPM: r e = r f +  (Mkt Premium) = 6.00 + 0.73(6) = 6.00 + 4.38 = 10.38%

8. 8 Kellogg’s WACC BV Weights WACC=.738*5.28 +.262*10.38 = 3.90 + 2.72 = 6.62% MV Weights WACC=.149*5.28 +.851*10.38 = 0.79 + 8.83 = 9.62%

9. 9 FINANCIAL STRUCTURE

10. 10 LEVERAGE

11. 11 EFFECTS OF LEVERAGE ON BETA  asset =  unlevered = W E *  equity  tgt =  asset / W E;tgt  port = w 1  1 + w 2  2 + w 3  3

12. 12 Target Cap Structure: 25% Debt, 75% Equity  asset =  unlevered = (E/V)*  equity =.851 * 0.73 =.621  tgt = (V/E) tgt *  asset = (1/.75) *.621 = 1.33 *.621 =.828 Example: Kelloggs

13. 13 r e = r f +  (Mkt Premium) = 6.00 + 0.83(6) = 6.00 + 4.98 = 10.98% WACC =.25(5.28) +.75(10.98) = 1.32 + 8.24 = 9.56% Example: Kelloggs