Chapter 12

Fundamentals of Corporate Finance

Fourth Edition

The Cost of Capital

Slides by Matthew Will

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Topics Covered
Geothermals Cost of Capital Weighted Average Cost of Capital (WACC) Capital Structure Required Rates of Return Big Oils WACC Interpreting WACC Flotation Costs

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Cost of Capital
Cost of Capital - The return the firms investors could expect to earn if they invested in securities with comparable degrees of risk. Capital Structure - The firms mix of long term financing and equity financing.

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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?

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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?

Market Value Debt $194 30% Market Value Equity $453 70% Market Value Assets $647 100%
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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?

Portfolio Return = (.3x8%) + (.7x14%) = 12.2%

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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? Portfolio Return = (.3x8%) + (.7x14%) = 12.2%
Interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2% (i.e. 8 % x .65).

WACC = (.3x5.2%) + (.7x14%) = 11.4%

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WACC
Weighted Average Cost of Capital (WACC) - The expected rate of return on a portfolio of all the firms securities.
Company cost of capital = Weighted average of debt and equity returns.

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WACC

rassets =
rassets
D V

total incom e value of investm ent s

(D x rdebt ) +(E x requity) V

rassets x rdebt x requity

E V
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WACC
Three Steps to Calculating Cost of Capital 1. Calculate the value of each security as a proportion of the firms market value. 2. Determine the required rate of return on each security. 3. Calculate a weighted average of these required returns.

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WACC
Taxes are an important consideration in the company cost of capital because interest payments are deducted from income before tax is calculated.

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WACC
Weighted -average cost of capital=

WACC =

D V

x (1 - Tc)rdebt +

] [

E V

x requity

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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.

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WACC
Example - continued Step 1 Firm Value = 4 + 2 + 6 = $12 mil

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WACC
Example - continued Step 1 Firm Value = 4 + 2 + 6 = $12 mil Step 2 Required returns are given

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WACC
Example - continued Step 1 Firm Value = 4 + 2 + 6 = $12 mil Step 2 Required returns are given Step 3

WACC =

4 12

x(1-.35).06 +

] (

2 12

x.12 +

) (

6 12

x.18

=.123 or 12.3%
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12- 17

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 Betas may change with capital structure

Bassets =

D V

x Bdebt +

] [

E V

x Bequity

Corporate taxes complicate the analysis and may change

our decision

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Measuring Capital Structure

In estimating WACC, do not use the Book Value of securities. In estimating WACC, use the Market Value of the securities. Book Values often do not represent the true market value of a firms securities.

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Measuring Capital Structure

Market Value of Bonds - PV of all coupons and par value discounted at the current interest rate.

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Measuring Capital Structure

Market Value of Bonds - PV of all coupons and par value discounted at the current interest rate.
Market Value of Equity - Market price per share multiplied by the number of outstanding shares.

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Measuring Capital Structure

Big Oil Book Value Balance Sheet (mil) Bank Debt $ 200 25.0% LT Bonds $ 200 25.0% Common Stock $ 100 12.5% Retained Earnings $ 300 37.5% Total $ 800 100%

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Measuring Capital Structure

Big Oil Book Value Balance Sheet (mil) Bank Debt $ 200 25.0% LT Bonds $ 200 25.0% Common Stock $ 100 12.5% Retained Earnings $ 300 37.5% Total $ 800 100%

If the long term bonds pay an 8% coupon and mature in 12 years, what is their market value assuming a 9% YTM?

16 16 16 216 PV .... 2 3 12 1.09 1.09 1.09 1.09 $185.70

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Measuring Capital Structure

Big Oil MARKET Value Balance Sheet (mil) Bank Debt (mil) $ 200.0 12.6% LT Bonds $ 185.7 11.7% Total Debt $ 385.7 24.3% Common Stock $ 1,200.0 75.7% Total $ 1,585.7 100.0%

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Required Rates of Return

Bonds

rd = YTM

Common Stock

re = CAPM = rf + B(rm - rf )
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Required Rates of Return

Dividend Discount Model Cost of Equity
Perpetuity Growth Model =

Div1 P0 = re - g

solve for re

Div1 re = + g P0
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Required Rates of Return

Expected Return on Preferred Stock
Price of Preferred Stock =

P0 =

Div1 rpreferred

solve for preferred

rpreferred Div1 = P0

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Flotation Costs
The cost of implementing any financing decision must be incorporated into the cash flows of the project being evaluated. Only the incremental costs of financing should be included. This is sometimes called Adjusted Present Value.

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Web Resources
Click to access web sites Internet connection required

http://pages.stern.nyu/~adamodar

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