Ch.13 WACC

Learning Objectives

-Calculate a firm's capital structure. Estimate the required rates of return on the securities issued by the firm. -Calculate the weighted-average cost of capital. -Understand when the weighted-average cost of capital is -or isn't- the appropriate discount rate for a new project. -Use the weighed-average cost of capital to value a business given forecasts of its future cash flows.

Valuing a Business

-The value of a business or project is usually computed as the discounted value of FCF out to a valuation horizon (H) -The valuation horizon is sometimes called the terminal value and is calculated like a perpetuity Formula

FCFFree Cash Flows (FCF)

-should be the theoretical basis for all PV calculations -more accurate measurement of PV than either Div or EPS -The market price does not always reflect the PV of FCF -When valuing a business for purchase, always use FCF

Debt has two costs

1. Return on debt 2. Increased cost of equity demanded due to the increase in risk.

Three Steps to Calculating Cost of Capital

1.Calculate the value of each security as a proportion (D/V) of the firm's market value 2.Determine the required RoR on each security 3.Calculate a weighted average of the after-tax return on the debt and the return on the equity

--Issues with WACC

1.Debt has two costs 2.Betas may change with capital structure 3.Corporate Taxes complicate the analysis and may change our decision.

There are two costs of debt financing The _______ cost of debt is the rate of interest bondholders demand The _______ cost is the required increase in return from equity

Explicit Implicit

Betas may change with capital structure

Formula

Market Value of Equity -

Market price per share multiplied by the number of outstanding shares

Market Value of Bonds -

PV of all coupons and par value discounted at the current YTM

Weighted Average Cost of Capital (WACC)

The expected rate of return on a portfolio of all the firm's securities, adjusted for tax savings due to interest payments -Company cost of capital = Weighted average of debt and equity returns

Capital Structure

The mix of long-term debt and equity financing

Cost of Capital

The return the firm's investors could expect to earn if they invested in securities with comparable degrees of risk

---To calculate the WACC, we must first calculate the rates of return that investors expect from each security. Expected returns on Expected returns on Expected returns on

bonds common stock preferred stock

In estimating WACC, do not use the ______

book value of securities

The WACC is an appropriate discount rate only for a project that is a ______ of the firm's existing business

carbon copy

In estimating WACC, use the _______

market value of the securities

1. Bonds

rd=YTM

2.Common Stock

re=CAPM=rf+b(rm-rf) or DDM Cost of Equity P=Div1/(re-g) (Same for Preferred)

Book values often do not represent the ________

true market value of a firm's securities

The company cost of capital is a ______ of returns demanded by debt and equity investors.

weighted average -WACC or Cost of Capital