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Lecture 10
Lecture 10
BUSINESS
SCHOOL
BFF2140
CORPORATE FINANCE I
Joshua Shemesh
MONASH
BUSINESS
SCHOOL
Readings
Chapter 13, pp. 386 – 405
MONASH
BUSINESS
SCHOOL
Learning Objectives
The idea is, we finance our assets through debt and equity and so in
everything we do we need to at least ensure we recover AT LEAST
the cost of financing.
Cost of Capital: Bringing it all together!
The cost of capital (COC) is the rate of return the firm must earn to
maintain its market value and attract investors.
projects with return > COC will improve the firm’s value
projects with return < COC will harm the firm’s value
So today:
Logically, the WACC is simply a combination of the cost of equity and cost of debt
as this is, after all, how we finance our assets!
Knowing the cost of capital can also help us determine the required
return for capital budgeting projects – minimum return to “break
even” and at least cover our costs!
Overall Cost of Capital of the Firm
Cost of Capital is the required rate of return on the three main types
of financing:
• WACC =
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡 𝑉𝐷
𝐹𝑟𝑎𝑐𝑡𝑖𝑜𝑛 𝑜𝑟 𝑤𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝐷𝑒𝑏𝑡 (𝐷%) = 𝑊𝐷 = =
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 (𝑉) 𝑉𝐷 + 𝑉𝐸
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑉𝐸
𝐹𝑟𝑎𝑐𝑡𝑖𝑜𝑛 𝑜𝑟 𝑤𝑒𝑖𝑔ℎ𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 (𝐸%) = 𝑊𝐸 = =
𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 (𝑉) 𝑉𝐷 + 𝑉𝐸
Example 1: calculating weights
(Market values vs Book-values)
Suppose Kenai Corp. has debt with a book (face) value of $10 million, trading at
95% of par value. It also has book equity of $10 million, and 1 million ordinary
shares trading at $30 per share.
Compute the capital structure market-value weights and book-value weights.
Which are more relevant, book- or market-values?
The market value weights are more relevant because they represent a more
current valuation of debt and equity
Example 2: calculating weights
Suppose 3M Corp. has debt with a book (face) value of $25 million, trading
at 110% of face value. It also has book equity of $35 million, and 3 million
ordinary shares trading at $25 per share. What weights should 3M use in
calculating its WACC?
– n = 25yrs x 2 = 50
– Coupon = $1,000 x (0.09/2) = $45
– M = $1,000
– Pb = $908.72
Example 3: Cost of Debt continued
CPN 1 FV
P0 1
y 1 y n 1 y n
$45 1 $1,000
$908.72 1
kd (1 k ) (1 k )50
50
d d
hence; YTM = rd = 5% semi-annual
or Annual Percentage Yield (APY) of 10% nominally
2. Convert to Effective Annual Yield (EAY) which is the
annual cost of debt: rd = (1+0.05)2 – 1 = 10.25%
3. Find the after-tax cost of debt: ri(1 – T) = 10.25(1 – 0.3) = 7.18%
Example 3: Cost of Bonds (debt)
– Continued (using HP10II+ calculator )
Cost of Preference Share Capital
Reminders
Preference shares generally pay a constant dividend every period
Dividends are expected to be paid every period forever
rP = 3 / 25 = 12.00%
Cost of Equity
Dt 1
P0
rE g
Dt 1
rE g
P0
Dt 1
recall, rE g
P0
$1.50
rE 0.051 0.111 or 11.10%
$25
Illustration:
Estimating the Dividend Growth Rate
Advantage
Disadvantages
E ( Ri ) RRF i E ( RM ) RRF
Example 6: CAPM
Advantages
Explicitly adjusts for systematic risk
Applicable to all companies, as long as we can compute beta
Disadvantages
Have to estimate the expected market risk premium, which
does vary over time
Have to estimate beta, which also varies over time
We are relying on the past to predict the future, which is not
always reliable (i.e. beta)
Example 7: Cost of Equity
Using SML:
rE = 6% + 1.5(9%) = 19.50%
Using DGM:
Dt 1
recall, rE g
P0
WACC WE rE WD rD 1T
After Tax WACC for
Unlevered (Equity only) firm
If the firm is an all equity firm and has no debt, then the WACC
formula collapses to:
WACC wE rE
WACC rE
That is, the WACC for an all equity firm is just the cost of
equity capital
Example 8: Comprehensive Problem
Packages R US (PRUS) Ltd. want to determine their WACC. Their 11% semi-annual
bonds (par value $1,000) are selling for $942.65 with 10 years remaining until maturity.
PRUS has 10,000 bonds currently on issue. The preference shares issued at $2.00 per
share, pay $0.20 dividends and are currently selling in the market for $1.60. There are 5
million preference shares outstanding. The firm also has 5 million ordinary shares on issue
which have a current market price of $5.00 each. Assume that the current risk-free rate is
7% and the return on market portfolio is 12%. PRUS has a beta which has been recently
estimated at 1.2. The tax rate is 30%.
C 1 Fn
PB 1
rd 1 rd n 1 rd n
55 1 1000
942.65 1
rd 1 r 20 1 rd 20
d
rd 0.06 or 6.00%
rD = (1+0.06)2 – 1 = 12.36%
DP 0.20
rp = 0.125 or 12.50%
N P 1.60
WACC wD rD (1 t ) w p r w E rE =11.94%
P
WACC for real ASX companies
Using the WACC to value a project
• Levered value:
FCF1 FCF2 FCF3
V0L ...
1 rWACC 1 rWACC 1 rWACC
2 3
Example 9
Key assumptions
Average risk:
We assume initially that the market risk of the project is equivalent to the
average market risk of the firm’s investments.
Potential errors when the firm uses its overall WACC to evaluate
individual projects
Example 10
Amalgamated Products is a well diversified industrial company (financed by equity only). The
risk-free rate is 5%, the expected return on market risk is 15%, and this firm’s beta is 1.3. The
firm has three divisions. They are United Foods, General Electronics and Associated Chemicals.
The company is planning to invest $10 million in each of its three divisions. The finance
manager has estimated the equity beta and cost of capital for each of its divisions by identifying
similar businesses in the market. The cost of capital for the company, Associated Products is
18%. The equity beta, cost of capital and IRR for the proposed new investments in each division
are given below.
a) Identify the projects that will be accepted using divisional cost of capital.
b) Identify the projects that will be incorrectly accepted or rejected if the firm’s overall cost of
capital is used as a hurdle rate.
Example 10: Solution
Explanation:
when IRR > divisional cost of capital project will be accepted.
when IRR < divisional cost of capital project will be rejected.
Example 10: Solution
Example 10: Solution
Electronics
0.2
R F
0.05
0
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8
Beta
Example 10
S M L
R F
0.05
0
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8
Beta
WACC for individual projects
56
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