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E (ri ) = rf + i (E (rMkt ) rf )
2. Cost of debt:
E (rd ) = r f + d (E (rMkt ) r f )
E
D
rE
rD
E D
E D
rwacc
E
D
rE
rD (1 W c )
E D
E D
E
D
D
rE
rD
rDW c
E D
E D
E D
Pretax WACC
Reduction Due
to Interest Tax Shield
WACCwithtaxes
Todays agenda:
Project cost of capital
Suppose we know:
a firm's captial struture (debt-equity ratio).
a firm's cost of capital
Question: If this firm would like to undertake a new
project, how should we compute the discount rate for
the new project?
Answer: it depends on the riskiness and capital
structure of the new project!
Project has:
1. Same risk as entire firm
2. Same financing as entire firm
Target
leverage
Target
leverage
Asset beta
D
E
L
A = =
D +
E
E+D
E+D
U
E
Simplified formula
We have:
D
E
L
L
A = =
D +
E
E+D
E+D
U
E
~
~
D ~L
E ~L
U
A = E = ~ ~ D + ~ ~ E
E+D
E+D
E
D
L
L
A = =
E
D +
E+D
E+D
D
1
L
L
E
E
D +
=
D
D
1+
1+
E
E
U
E
~
~ ~
~ L E + D U D ~L
E = ~ E ~ D
E
E
~
~
D U D ~L
= 1 + ~ E ~ D
E
E
Where
~
~
D and E are computed using new target leverage
Final step:
Apply CAPM with the new equity beta
~L
~
rE = rf + E (E (rMkt ) rf )
~
r
Cost of the debt D is usually given.
Where:
E ~
D ~
= ~ ~ rE + ~ ~ rD (1 )
E+D
E+D
~
~
E
D
~ ~ and ~ ~ are computed at the target leverage
E+D
E+D
Unlever beta
Relever beta to target leverage
B. Cost of debt:
Depends on data given in the problem
Often assumed to be same as current cost of debt
Conglomerates:
What could be the consequences of applying firm-wide
WACC for projects in different divisions?
Assume further:
rE=5%+1*8%= 13%
rE=5%+1.5*8%= 17%
Mean
Security Market Line
(SML)
17%
15%
13%
Consumer
Goods Division
5%
1.5
Beta
Empirical evidence
WACC fallacy:
Def.: To apply the firm-wide WACC across all divisions
Wrong discount rate applied in their NPV rule
Leads to distortions in capital budgeting
Evidence:
1. Survey: Bierman (1993), Graham and Harvey (2001)
Most CEOs admit being susceptible to the WACC fallacy
With a picture:
Industry
firm 1
Industry
firm 2
E
D
L
L
A = =
E
D +
E+D
E+D
U
E
E/(E+D):
Nordstrom: 0.65
Saks: 0.5
Sears Holdings: 0.77
E+D
~
~ ~
~ L E + D U D ~L
E = ~ E ~ D
E
E
II. Compute cost of equity for your project
CAPM with new levered beta
With a picture:
Industry
firm 1
Industry
firm 2
Target
leverage
for project
Summing up
Discount rate:
A key element to valuation and capital budgeting
Appropriate discount rate depends on:
Nature of cash flows (riskiness and maturity)
Bonds
Equity
Entire firm
All types of projects