FINE 3010-01 Financial Management

1. FINE 3010-01Financial Management Instructor: RogérioMazali Lecture 14: 12/05/2011

2. FINE 3010-04Instructor: RogérioMazali Fundamentals of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Alan J. Marcus McGraw Hill/Irwin Chapter 13: The Weighted-Average Cost of Capital and Company Valuation

3. Agenda • Cost of Capital of an All-Equity Firms • Cost of Capital of Leveraged Firms: the Weighted- Average Cost of Capital (WACC) • Use Market Weights, not Book Weights • Taxes and the WACC • Three (or more) Sources of Funding • Measuring Capital Structure • Expected Rates of Return on Bonds • Expected Return on Common Stock • Expected Return on Preferred Stock • Valuing Entire Businesses

4. Cost of Capital of All-Equity Firms • According to the CAPM, the expected return of any security i is given by: E(Ri) = rf + βi * [E(RM) – rf] where βi= Cov(Ri, RM) / Var(RM). That is, if the firm is 100% equity financed, we can discount the cash flows of security i at this rate!

5. Cost of Capital of All-Equity Firms An all-equity firm is considering an investment opportunity with these features: Initial Investment: 350,000 Cash Flows (5 years): 100,000 Risk-free Rate: 3% E(RM): 9% Beta of our firm is 1.2 AND the project has the same risk as the firm

6. Cost of Capital of All-Equity Firms Step 1: Calculate the Cost of Equity Capital E(R) = rf + β [E(RM) – rf ]= 0.03 + 1.2 * [0.09 – 0.03] = 0.102 Step 2: Calculate the NPV of the project

7. Cost of Capital of All-Equity Firms 100,000 / 1.102

8. Cost of Capital of Leveraged Firms: the Weighted- Average Cost of Capital (WACC) • Consider now a firm that has been financed by both debt and equity: • Bondholders expect return rdebt on their investment • Shareholders expect return requity on their investment • Q: How much return should a project give in order to be considered viable? • A: Enough money to pay both shareholders and bondholders • Q: And how much is that, exactly?

9. Cost of Capital of Leveraged Firms: the Weighted- Average Cost of Capital (WACC) • Consider the following example: Geothermal Corp. • Company debt pays return rdebt = 8%. • Company stock pays return requity = 14%. • Therefore, shareholders require extra requity × E = 0.14 × $453 mi = $63.42 mi. • Also, bondholders require extra rdebt × D = 0.08 × $194 mi = $15.52 mi. • Newly created assets would be then = $63.42 mi + $15.52 mi = $78.94 mi, and ROA = $78.94/$647 = .122 = 12.2%.

10. Cost of Capital of Leveraged Firms: the Weighted- Average Cost of Capital (WACC) • This procedure is known as the Weighted Average Cost of Capital (WACC).

11. Taxes and the WACC • So far we have not considered the effect of taxes on the cost of capital. • Why are taxes important? • Note that interest payments are tax-deductible: • For each $1 paid in interest, taxable income is reduced by $1, and the firm’s tax bill is reduced by $0.35 (if the firm is in the 35% tax rate bracket).

12. Taxes and the WACC • We can now state our tax-included WACC formula: • In our Geothermal Example, we have:

13. Valuing an Entire Business • Example: I0 = 50 m Cash Flows (for 6 years) = 12 m each year Debt/Equity ratio: 0.6 Cost of Debt: 15.15% Cost of Equity: 20% Tax Rate: 34% Is this a good project?

14. Valuing an Entire Business Step 1: Calculate the Cost of Equity Capital Step 2: Calculate the Cost of Debt Step 3: Calculate the WACC Step 4: Calculate the PV & the NPV of the project

15. Valuing an Entire Business Step 1: Calculate the Cost of Equity Capital E(RE) = 0.20 Step 2: Calculate the Cost of Debt E(RD) = 0.1515 Step 3: Calculate WACC Additional input: Debt/Value = 0.6 /(0.6 + 1) = 0.375 Equity/Value = 1- 0.375 = 0.625 WACC = 0.375 * 0.1515 * (1 – 0.34) + 0.625 * 0.2 = 0.1625 Step 4: Calculate the NPV of the project

16. Valuing an Entire Business

17. Valuing an Entire Business • Another Example:

18. Valuing an Entire Business Market Value of Debt: 60 * 120 % = 72 Market Value of Equity: 5 * 20 = 100 Debt / (Debt + Equity) = 72 / 172 = 41.9 % Equity / (Debt + Equity) = 100 / 172 = 58.1 % Cost of Equity: 0.03 + 1.4 [0.1 – 0.03] = 0.128 Cost of Debt: 0.12 (equal to YTM) WACC = 0.419 * 0.12 * 0.66 + 0.581 * 0.128 = 10.75%

19. Valuing an Entire Business TV5 = 2.5 / (0.1075 – 0.03)

20. Three (or more) Sources of Funding • Consider the case in which the firm is funded by: • Debt • Common stock • Preferred stock • WACC formula can be adapted to include all 3 sources of funding: • In general, if Vn is the amount of the firm’s assets financed by means n, then:

21. Comments • When calculating capital structure, use market values, not book values. Market Value of Bonds - PV of all coupons and par value discounted at the current YTM. Market Value of Equity - Market price per share multiplied by the number of outstanding shares.

22. Comments • Required Rates of Return: • Bonds: rdebt = YTM; • Common Stock: • CAPM: • DDM: • Preferred Stock: • Fixed dividend: • Bank Loans: Interest on Bank Loan

23. Comments • The WACC is an appropriate discount rate only for a project that is a carbon copy of the firm's existing business • There are two costs of debt financing. The explicit cost of debt is the rate of interest bondholders demand. The implicit cost is the required increase in return from equity. • When evaluating a business, always use Free Cash Flows (FCF) • FCF = Op. CF – Inv. In PPE and working capital

24. Example: Concatenator Manufacturing • Capital Structure: 60% Equity, 40% Debt • Cost of debt: 5% • Cost of equity: 12% • Growth after horizon period: 5% • Cash Flows: See Next Table

25. Example: Concatenator Manufacturing

26. Comments • Example: ConcatenatorManufactoring