1 / 25

Session 6

Session 6. Cost of Capital. 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. COST OF CAPITAL.

alexander-martin
Download Presentation

Session 6

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Session 6 • Cost of Capital

  2. COST OF CAPITAL • WEIGHTED AVG COST OF CAPITAL (WACC) • r = wdrd + were • wd = proportion of assets funded by debt • rd = After-tax cost of debt • we = proportion of assets funded by equity • re = cost of equity

  3. COST OF CAPITAL WACC = 40(.10)+10(.15)+50(.18) = 4 + 1.50 + 9 = 14.50% • rd = 10% rp = 15% re = 18% • wd = 40% wp = 10% we = 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

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

  5. Cost Of Debt • ESTIMATING COSTS • DEBT: BANK RATE • YIELD TO MATURITY ON BONDS • Example: 10 year 8% coupon bond is trading at $951 • Yield to maturity is 8.75% • [N=20; PV=-951; Pmt=40; FV=1000]

  6. Cost Of Equity • Capital Asset Pricing Model • rf = Risk Free Rate •  = Relative Risk of Firm • Mkt Prem = Risk Premium Paid on Average Company • = rmkt - rf re = rf +  (Mkt Premium)

  7. Cost of Equity: Components • Risk Free Rate: • 10-year Treasury Bond Rate • 3-Month Treasury Bill Rate • Market Premium: • Historic Average of 7% to 8% • Growth in economy plus inflation: 5% to 6%

  8. Example: Boeing • Book Value % . • Debt 17,032 61% • Equity 10,825 39% • 27,857 100% • Mkt Value % . • Debt 17,032 30% • Equity 40,205 70% • (837.6*48)57,237 100%

  9. COST OF CAPITAL • Debt: Bond Rate: 9.73% • rd = 9.73 * (1-0.34) = 6.42% • CAPM: re = rf + (Mkt Premium) • = 5.50 + 0.935(5.00) • = 5.50 + 4.68 • = 10.18%

  10. BOEING’S WACC • BV Weights • WACC = .61*6.42 + .39*10.18 • = 3.92 + 3.97 • = 7.89% • MV Weights • WACC = .30*6.42 + .70*10.18 • = 01.93 + 7.13 • = 9.05%

  11. Boeing Case: Changing Debt • Target Cap Structure: 60% Debt, 40% Equity • WACC = .6*6.42) + .4(10.18) • = 3.85 + 4.07 • = 7.92%

  12. Effect of Debt on the WACC

  13. FINANCIAL STRUCTURE

  14. LEVERAGE

  15. Effect of Leverage on Beta • asset = unlevered = WE* equity • tgt = asset / WE;tgt • port = w11 + w22 + w33

  16. Boeing Case: Beta Effect • Target Cap Structure: 60% Debt, 40% Equity • asset = unlevered = (WE)* equity • = .70*.935 • = .655 • tgt = asset / (WE)tgt • = .655/.40 • = 1.64

  17. BA Case: Beta Effect(contd.) • re = rf + (Mkt Premium) • = 5.5 + 1.64(5) • = 5.5 + 8.2 • = 13.7% • WACC = .60(6.42) + .40(13.7) • = 3.85 + 5.48 • = 9.33%

  18. BA Case: Debt Cost Effect • re = rf + (Mkt Premium) • = 5.5 + 1.64(5) • = 13.7% • rd = 13.5 * (1-.34) = 8.91% • WACC = .60(8.91) + .40(13.7) • = 5.35 + 5.48 • = 10.83%

  19. EFFECT OF FIN STRUCTURE ON WACC

  20. Plot of Boeing’s WACC

  21. Boeing’s WACC

  22. Notes on WACC Computations • 1) Equity versus entity approach • 2) Peer group analysis – industry versus company betas. • 3) Leveraged and unleveraged betas. • 4) F: Flexibility • R: Risk • I: Income • C: Control • T: Taxes

  23. Observations on Financial Structure • 1)You can make a lot more money by smart investment decisions (real assets) than by smart financing decisions. • 2)It is very hard to guess direction of the markets. • 3)Exotic securities of value only if you are first in the queue. And then you better know what you are doing!

  24. Observations on Financial Structure • 4)Think about distress costs. These are less important (i.e. you can have more debt) if: • Tangible assets • Lower growth • Lower R & D • Less Reliance advertising

  25. Observations on Financial Structure • 5)Consider impact on firm of: • Employee losses • Customer defections • Lost opportunities (NPV > 0 projects foregone) • Slower investment • R & D • Advertising • Refurbishment/Replacement • Technology

More Related