FINS3625

Applied Corporate Finance

Lecture 3 (Chapter 13) Jared Staneld March 14, 2012

Figure 13.2 Two Capital Structures

13.1 A First Look at the Weighted Average Cost of Capital

Opportunity Cost and the Overall Cost of Capital Weighted Averages and the Overall Cost of Capital
Weighted Average Cost of Capital (WACC) Market-Value Balance Sheet
Market Value of Equity + Market Value of Debt = Market Value of Assets (Eq. 13.1)

13.1 A First Look at the Weighted Average Cost of Capital

Weighted Average Cost of Capital CalculaWons
Leverage
Unlevered Levered

13.1 A First Look at the Weighted Average Cost of Capital

Weighted Average Cost of Capital CalculaWons
The Weighted Average Cost of Capital: Unlevered Firm
rWACC = Equity Cost of Capital

13.1 A First Look at the Weighted Average Cost of Capital

Weighted Average Cost of Capital CalculaWons
The Weighted Average Cost of Capital: Levered Firm

(Eq. 13.2)

13.2 The Firms Costs of Debt and Equity Capital

Cost of Debt Capital
Yield to Maturity and the Cost of Debt
The Yield to Maturity is the yield that investors demand to hold the rms debt (new or exisWng).

Taxes and the Cost of Debt

EecWve Cost of Debt rD (1 - TC) (Eq. 13.3) where TC is the corporate tax rate.

EecWve Cost of Debt

Problem:
By using yield to maturity on Gap Inc.s debt, we nd that its pre-tax cost of debt is 7.13%. If Gap Inc.s tax rate is 40%, what is its eecWve cost of debt?

EecWve Cost of Debt

SoluWon: Plan:
We can use Eq. 13.3 to calculate GAPs eecWve cost of debt: rD =7.13%% (pre-tax cost of debt) TC =40% (corporate tax rate)

EecWve Cost of Debt

Execute:
Gap Inc.s eecWve cost of debt is 0.0713 (1-0.40)= .0428 = 4.28%

EecWve Cost of Debt

Evaluate:
For every $1000 it borrows, Gap Inc. pays its bondholders 0.0713($1000) = $71.30 in interest every year. Because it can deduct that $71.30 in interest from its income, every dollar in interest saves Gap Inc. 40 cents in taxes, so the interest tax deducWon reduces the rms tax payment to the government by 0.40($71.30) =$28.52. Thus Gap Inc.s net cost of debt is the $71.30 it pays minus the $28.52 in reduced tax payments, which is $42.78 per $1,000 or 4.28%.

13.2 The Firms Costs of Debt and Equity Capital

Cost of Preferred Stock Capital
Div pfd Prefered Dividend Cost of Preferred Stock Capital = = Preferred Stock Price Ppfd
(Eq. 13.4)

Assume DuPonts class A preferred stock has a price of $66.67 and an annual dividend of $3.50. Its cost of preferred stock, therefore, is $3.50 $66.67 = 5.25%

13.2 The Firms Costs of Debt and Equity Capital

Cost of Common Stock Capital
Capital Asset Pricing Model
From Chapter 12
1. EsWmate the rms beta of equity, typically by regressing 60 months of the companys returns against 60 months of returns for a market proxy such as the S&P 500. 2. Determine the risk-free rate, typically by using the yield on Treasury bills or bonds.

13.2 The Firms Costs of Debt and Equity Capital

Cost of Common Stock Capital
Capital Asset Pricing Model
From Chapter 12
3. EsWmate the market risk premium, typically by comparing historical returns on a market proxy to contemporaneous risk-free rates. 4. Apply the CAPM:
Cost of Equity = Risk-Free Rate + Equity Beta Market Risk Premium

Return CalculaWon Reminder

No Stock Split Returns: Rt = (Pt Pt-1 + Dt)/Pt-1 X for Y Stock Split Returns: Rt = ((X/Y)*Pt Pt-1 + (X/Y)*Dt)/Pt-1

13.2 The Firms Costs of Debt and Equity Capital

Cost of Common Stock Capital
Capital Asset Pricing Model
Assume the equity beta of DuPont is 1.37, the yield on ten-year Treasury notes is 3%, and you esWmate the market risk premium to be 6%. DuPonts cost of equity is 3% + 1.37 6% = 11.22%

13.2 The Firms Costs of Debt and Equity Capital

Cost of Common Stock Capital
Constant Dividend Growth Model

(Eq. 13.5)

13.2 The Firms Costs of Debt and Equity Capital

Cost of Common Stock Capital
Constant Dividend Growth Model
Assume in mid-2010, the average forecast for DuPonts long-run earnings growth rate was 6.2%. With an expected dividend in one year of $1.64 and a price of $36.99, the CDGM esWmates DuPonts cost of equity as follows (using Eq. 13.5):

Cost of Equity =

Div1 $1.64 +g= + 0.062 = 0.106 or 10.6% PE $36.99

Table 13.1 EsWmaWng the Cost of Equity

13.3 A Second Look at the Weighted Average Cost of Capital

WACC EquaWon
rwacc = rEE% + rpfd P% + rD(1 - TC)D%
(Eq. 13.6)

For a company that does not have preferred stock, the WACC condenses to: rwacc = rEE% + rD(1 - TC)D%
(Eq. 13.7)

13.3 A Second Look at the Weighted Average Cost of Capital

WACC EquaWon
In mid-2010, the market values of DuPonts common stock, preferred stock, and debt were $30,860 million, $187 million, and $9543 million, respecWvely. Its total value was, therefore, $30,860 million + $187 million + $9543 million = $40,590. Given the costs of common stock, preferred stock, and debt we have already computed, DuPonts WACC in late 2010 was:

13.3 A Second Look at the Weighted Average Cost of Capital

WACC EquaWon
! 30,860 " ! 187 " ! 9,543 " WACC = 11.22% $ + 5.25% $ + (1 0.35 )3.66% $ % % % & 40,590 ' & 40,590 ' & 40,590 ' = 9.11%

CompuWng the WACC

Problem:
The expected return on Macys equity is 10.8%, and the rm has a yield to maturity on its debt of 8%. Debt accounts for 16% and equity for 84% of Macys total market value. If its tax rate is 40%, what is this rms WACC?

CompuWng the WACC

SoluWon: Plan:
We can compute the WACC using Eq. 13.7. To do so, we need to know the costs of equity and debt, their proporWons in Macys capital structure, and the rms tax rate. We have all that informaWon, so we are ready to proceed.

CompuWng the WACC

Execute: rwacc = rEE% + rD (1 -TC)D% = (0.108)(0.84) + (0.08)(1 -0.40)(0.16) = .0984 or 9.84%

CompuWng the WACC

Evaluate:
Even though we cannot observe the expected return of Macys investments directly, we can use the expected return on its equity and debt and the WACC formula to esWmate it, adjusWng for the tax advantage of debt. Macys needs to earn at least a 9.84% return on its investment in current and new stores to saWsfy both its debt and equity holders.

Figure 13.3 WACCs for Real Companies

13.3 A Second Look at the Weighted Average Cost of Capital

Methods in PracWce
Net Debt
Net Debt = Debt Cash and Risk-Free SecuriWes
(Eq. 13.8)

rWACC

! Market Value of Equity " ! " Net Debt = rE $ % + rD (1 TC ) $ % Enterprise Value Enterprise Value ' & ' &

13.3 A Second Look at the Weighted Average Cost of Capital

Methods in PracWce
The Risk-Free Interest Rate
Most rms use the yields on long-term treasury bonds

The Market-Risk Premium

Since 1926, the S&P 500 has produced an average return of 7.1% above the rate for one-year Treasury securiWes Since 1959, the S&P 500 has shown an excess return of only 4.7% over the rate for one-year Treasury securiWes

Table 13.2 Historical Excess Returns of the S&P 500 Compared to One-Year Treasury Bills and Ten-Year U.S. Treasury SecuriWes

13.4 Using the WACC to Value a Project

Levered Value
The value of an investment, including the benet of the interest tax deducWon, given the rms leverage policy

WACC ValuaWon Method

DiscounWng future incremental free cash ows using the rms WACC, which produces the levered value of a project

13.4 Using the WACC to Value a Project

Levered Value
V0L = FCF3 FCF1 FCF2 + + + ... 2 3 1 + rWACC (1 + rWACC ) (1 + rWACC )
(Eq. 13.9)

The WACC Method

Problem:
Suppose Starbucks is considering introducing a new Frappuccino that is orange to be called Orange Mocha Frappuccino. The rm believes that the coees avor, color, and appeal to ridiculously good-looking male models will make it a success.

The WACC Method

Problem:
The risk of the project is judged to be similar to the risk of the company. The cost of bringing the Orange Mocha Frappuccino to market is $280 million, but Starbucks expects rst-year incremental free cash ows from Orange Mocha Frappuccino to be $80 million and to grow at 5% per year thereaqer. Should Starbucks go ahead with the project?

The WACC Method

SoluWon: Plan:
We can use the WACC method shown in Eq. 13.9 to value OMF and then subtract the upfront cost of $280 million. We will need Starbucks WACC, which was esWmated in Figure 13.3 as 11.0%.

The WACC Method

Execute:
The cash ows for OMF are a growing perpetuity. Applying the growing perpetuity formula with the WACC method, we have:

V0L = FCF0 +

FCF1 $80 million = 280 + = $1,053.33million ($1.05billion) rWACC g 0.11 .05

The WACC Method

Evaluate:
The OMF project has a posiWve NPV because it is expected to generate a return on the $280 million far in excess of Starbucks WACC of 11.0%. As discussed in Chapter 3, taking posiWve-NPV projects adds value to the rm. Here, we can see that the value is created by exceeding the required return of the rms investors.

13.4 Using the WACC to Value a Project

Key AssumpWons
Average Risk
We assume iniWally that the market risk of the project is equivalent to the average market risk of the rms investments

Constant Debt-Equity RaWo

We assume that the rm adjusts its leverage conWnuously to maintain a constant raWo of the market value of debt to the market value of equity

13.4 Using the WACC to Value a Project

Key AssumpWons (contd)
Limited Leverage Eects
We assume iniWally that the main eect of leverage on valuaWon follows from the interest tax deducWon and that any other factors are not signicant at the level of debt chosen

13.4 Using the WACC to Value a Project

WACC Method ApplicaWon: Extending the Life of a DuPont Facility
Suppose DuPont is considering an investment that would extend the life of one of its chemical faciliWes for four years The project would require upfront costs of $6.67 million plus a $24 million investment in equipment The equipment will be obsolete in four years and will be depreciated via straight-line over that period

13.4 Using the WACC to Value a Project

WACC Method ApplicaWon: Extending the Life of a DuPont Facility
During the next four years, however, DuPont expects annual sales of $60 million per year from this facility Material costs and operaWng expenses are expected to total $25 million and $9 million, respecWvely, per year DuPont expects no net working capital requirements for the project, and it pays a tax rate of 35%.

Table 13.3 Expected Free Cash Flow from DuPonts Facility Project

13.4 Using the WACC to Value a Project

WACC Method ApplicaWon: Extending the Life of a DuPont Facility
V0L = 19 19 19 19 + + + = $61.41 million 2 3 4 1.0911 1.0911 1.0911 1.0911

NPV = $61.41 million - $28.34 million = $33.07 million

13.4 Using the WACC to Value a Project

Summary of WACC Method
1. Determine the incremental free cash ow of the investment 2. Compute the weighted average cost of capital using Eq. 13.6 3. Compute the value of the investment, including the tax benet of leverage, by discounWng the incremental free cash ow of the investment using the WACC

13.5 Project-Based Costs of Capital

Cost of Capital of a New AcquisiWon
Suppose DuPont is considering acquiring Weyerhaeuser, a company that is focused on Wmber, paper, and other forest products Weyerhaeuser faces dierent market risks than DuPont does in its chemicals business What cost of capital should DuPont use to value a possible acquisiWon of Weyerhaeuser?

13.5 Project-Based Costs of Capital

Cost of Capital of a New AcquisiWon
Because the risks are dierent, DuPonts WACC would be inappropriate for valuing Weyerhaeuser Instead, DuPont should calculate and use Weyerhaeusers WACC of 8.8% when assessing the acquisiWon

13.5 Project-Based Costs of Capital

Divisional Costs of Capital
Now assume DuPont decides to create a forest products division internally, rather than buying Weyerhaeuser What should the cost of capital for the new division be?
If DuPont plans to nance the division with the same proporWon of debt as is used by Weyerhaeuser, then DuPont would use Weyerhaeusers WACC as the WACC for its new division

Walker, Texas Yogurt

Suppose you are the financial planning director for Martial Arts Australia. After watching an Activia Yogurt commercial, you think that yogurt that helps you go to the bathroom is a good product, but needs to toughen up its image You decide Martial Arts Australia will introduce a new Chuck Norris yogurt that roundhouses anyone that makes fun of you for eating fiber-filled yogurt. The firm believes that the new yogurt will make it less embarrassing to consume this type of yogurt in public How would you come up with the required rate of return? MAAs WACC is 6.6%, the risk-free rate is 3.0% and the market risk premium is 5.4%

A Project in a New Line of Business

SoluWon: Plan:
The rst step is to idenWfy a company operaWng in MAAs targeted line of business. Danone SA is a well-known marketer of yogurt. In fact, that is almost all Danone does. Thus the cost of capital for Danone would be a good esWmate of the cost of capital for MAAs proposed yogurt business.

A Project in a New Line of Business

SoluWon: Plan (contd):
Suppose you nd that the beta of Danone is 0.4. With this beta, the risk- free rate, and the market risk premium, you can use the CAPM to esWmate the cost of equity for Danone. Danone has a market value debt/assets raWo of .58, and its cost of debt is 3.8%. Its tax rate is 28%.

A Project in a New Line of Business

Execute:
Using the CAPM, we have:
Coca Cola ' s cost of equity = Risk free rate + Coca Cola ' s beta Market Risk Premium = 3% + .4 5.4% = 5.8%

To get Danones WACC, we use equaWon 13.6. Danone has no preferred stock, so the WACC is:

rWACC = rE E % + rD (1 TC )D% = 5.8%(0.42) + 3.8%(1 .28)(0.58) = 4.02%

A Project in a New Line of Business

Evaluate:
The correct cost of capital for evaluaWng a beverage investment opportunity is 4.02%. If we had used the 6.6% cost of capital that is associated with MAAs exisWng business, we would have mistakenly used too high of a cost of capital. That could lead us to reject the investment, even if it truly had a posiWve NPV.

13.6 When Raising External Capital Is Costly

Issuing new equity or bonds carries a number of costs
Issuing costs should be treated as cash outlows that are necessary to the project They can be incorporated as addiWonal costs (negaWve cash ows) in the NPV analysis

Transforming equity into asset

The assets of a firm are equal to its liabilities (debt) + equity:
Assets = Debt + Equity

The of a portfolio of securities is a weighted average of the s of the securities

Transforming equity into asset

Since the assets of a firm are claimed by a portfolio of debt and equity we can write:
Assets = Equity
Equity Debt + Debt Debt + Equity Debt + Equity

Thus, the firm's asset beta is a weighted average of the debt and equity betas. The assumption that Debt = 0 is often made: Equity Debt + Equity

Assets = Equity

Transforming equity into asset

We can rewrite the formula for the asset beta to get an expression for the equity beta (equity risk):

Assets = Equity

Equity , which means that : Debt + Equity

Debt Equity = Assets + Assets Equity What does this equation say about where equity risk comes from?

Asset Beta Example

Your company has two divisions. One sells beverages and the other manufactures and sells fancy candy bars through a direct retail channel You feel that Rocky Mountain Chocolate Factory is a comparable publicly traded company for your candy bars division. If RMCFs beta for its common stock is 0.96 and its debt is 10% of its capital structure What is the appropriate discount rate for projects in your candy bar division? Assume a risk free rate of 3% and a risk premium (market return minus risk free rate) of 8%

Solution
We can use RMCFs Beta of equity to solve for RMCFs Beta of Assets to obtain a measure of the project risk of your division:
Assets
Equity = Equity Debt + Equity

Assets = 0.96 (.90 ) = 0.86

E ( R ) = rf + Assets ( E ( RM ) rf

E ( R ) = 0.03 + 0.86 ( 0.08 ) = 0.0988