FINANCIAL MANAGEMENT II : WEIGHTED AVERAGE COST OF CAPITAL (LAYUG)

WACC Optimal Capital Structure (OCS): maximize

Cost of obtaining funds; shareholder wealth (maximize stock price) and
Primarily for investing activities. minimize WACC;
Basis: Using DDM, higher stock price, lower rs,
Decision Process lower WACC; Using CVM, lower WACC, higher MV of
Personal Finance: Financing, Investing, Operating; Firm,
Corporate Finance: higher MV of Equity, higher stock price;
> Investing (Look); Current capital structure: based on BS; same with
> Financing (WACC determination); OCS? can be the OCS?
> Investing (Accept?); Hierarchy of amounts: 1) Target; 2) Market Value
> Financing (Raise funds); (Equity = Shares x Stock Price; Debt = PV of CFs
> Investing (Expenditure); using DCF);
> Operating (Day-to-day) 3) Book Value (PS = Par Value; CS = Par Value,
APIC/Share
Importance (Use) of WACC premium, RE; Debt = LT debt in the books
1. Capital Budgeting (NPV,IRR); Inclusion: LT sources; investor supplied funds;
2. Valuation of Stocks (CVM); Exclusion: CL such as AP and accruals (not investor
3. Valuation for Mergers/Acquisitions (DCF). supplied);
Other CL: ST interest-bearing note and current
WACC and Capital Budgeting portion of LT debt (included accdg to Brigham);
A = D + E; ST debt used to finance LT investment, ST debt rolled
Rate of return of A vs. Cost of Capital (WACC) of D over and becomes permanent (included accdg to
+ E; this is IRR; Brealy);
Benefits (PV of CFs using Cost of Capital, or WACC, Other CL (excluded accdg to Gitman; CL in general are
as discount rate) vs Cost investment (in A); this is excluded)
NPV. Illustration
Question: Theory 10-3, page 359;
WACC Formula Answer: Use 1st - target capital structure, 2nd MVs, 3rd
WACC BVs
= [Wd x rd (1-tax rate)] + (Wp x rp) + (Wc x rs) Question: Problem 10-9, page 360;
= [(D/V) x rd (1- tax rate)] + [(C/V) x rs] + [(P/V) x rp] Solution:
Wd = weight of debt; Wp = weight of PS; Wc = > D = P1,152, C = 576 shares x P4 = P2,304
weight of CS > V = P1,152 + P2,304 = P3,456
D = Value(MV) of debt; P = Value(MV) of PS; > Wd = P1,152/P3,456 = 33.33%;
C = Value (MV) of CS Wc = P2,304/P3,456 = 66.67%
Rd = return on debt; interest rate; > WACC = [13% x (1-40%) x 33.33%]
rd(1-tax rate) = after-tax cost of debt + (16% x 66.67%)
rp = return or cost of preferred stock; = 13.27%
rs = return or cost of equity; RE (internal equity); Return on Debt (rd) and After-tax Cost of Debt
re = return or cost of new CS (external equity) Interest rate; YTM; before-tax cost of debt;
Sample illustration 3 Types (Gitman): 1) Market quotations;
Given: 2) YTM Exact; 3) YTM Approximate;
D = P15M, C = P25M, P = P10M; rd = 5%, rp = 10%, Effect of interest expense on income/cash flow:
rs = 15%, tax rate = 30% lowers income before taxes, lower income tax
Solution: payments (costs on taxes), creates tax savings;
= 30% x 5%(1-30%)+ 20%x10% + 50% x 15% After-tax cost of debt = rd x (1-tax rate).
= 10.55% Sample illustration:
Given:
Capital Structure If the interest rate is 8% and the tax rate is
Proportion of debt, PS and CS; 30%, the after-tax cost of debt is
Solution:
= 8% x (1-30%) = 5.60%
FINANCIAL MANAGEMENT II : WEIGHTED AVERAGE COST OF CAPITAL (LAYUG)
interest rate on corporate bond,
Cost of New Debt RP = judgmental risk premium (3-5%);
Cost debt is the cost of new debt to be obtained, not in Brealy and Gitman;
not of the outstanding debt (BS); c) DDM (Constant growth) = (D1/Po) + g(or
Marginal cost of debt; not historical cost of debt; CGY), where g = plowback ratio x ROE
If silent, cost of new debt = cost of current debt. Question: Theory 10-2, page 359;
Cost of Debt, If Silent Answer: Increase in rf increases both cost of
Before-tax or after-tax? debt and cost of equity
Own: After-tax; point of view of the corporation; Question: Problem 10-6, page 360;
interest is tax-deductible; Solution:
3 Authors: Not silent; a) rs (DCF) = (P2.14/P23) + 7% = 16.30%
After-tax: cost of debt for calculating WACC b) rs (CAPM) = 9% + 1.60 (13%-9%) = 15.40%
and cost of debt including tax deductibility c) rs (BY + RP) = 12% + 4% = 16%
of interest (Brigham); net cost of debt d) rs (average) = (16.30% + 15.40% + 16%)/3
(Gitman); = 15.90%
Images of WACC: before-tax. Question: Problem 10-8, page 360;
Flotation Costs Solution:
Debt has flotation costs but small thats why rs = [(P2 x 1.07)/P22.50] + 7% = 16.51%
ignored in computation, in general; WACC = [40% x 12% x (1-40%)] +
If given, consider in computing for the rd (YTM); (60% x 16.51%) = 12.79%
Expected return on debt or cost of debt: should be Question: Problem 10-3, page 359;
used as rd if given and not the same with YTM; Solution:
considers probability of default and callable 9.96% = [40% x 9% x (1-40%)] + (60% x rs)
provision; rs = 13%
YTM: to be used assuming probability of default is
low or not callable.
Illustration
Question: Problem 10-1, page 359;
Solution:
After-tax cost of debt = 12% x (1-35%)
= 7.80%
Cost of Preferred Stock (rp)
Cost of Preferred Stock (PS) = Dp/Pp, where Dp =
Dividend of PS and Pp = Price of PS;
Preferred stocks have no tax adjustment since PS
dividends are not tax-deductible, hence no tax
savings.
Sample Illustration
Question: Problem 10-2, page 359;
Solution: rp = P3.80/P47.50 = 8%

Cost of Equity (Internal and External)

rs; rate of return on equity;
Two sources: internal (RE) and external (New CS);
Opportunity cost principle of using RE: dividends to
be received should have been invested to earn a
return;
rs = rate of return on retained earnings or cost of
retained earnings
3 Ways to compute for rs (cost of RE):
a) CAPM = rf + B (MRP);
b) Bond yield (BY) plus risk premium
= bond yield + RP; where bond yield =