8/13/2019 Fund.finance Lecture 8 Capital Structure
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Capital
structure_Cost ofCapital
Lecture
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Agendas
Capital structureWeighted Average Cost of Capital (WACC)Calculating WACCMeasuring Capital StructureCalculating Required Rates of ReturnFirm vesus Project
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What’s the Big Idea?
• Earlier lectures on capital budgeting focusedon the appropriate size and timing of cash
flows.
• This lecture discusses the appropriate
discount rate when cash flows are risky.
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Capital structure
Capital Structure - The firm’s mix of long termdebt financing and equity financing.
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Cost of Capital - The return thefirm’s investors could expect to earnif they invested in the securities
having comparable degrees of risk.
Cost ofequity
Cost ofpreferred
stock
Cost ofdebts (bank
loans)
Cost ofdebts
(bonds)
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WACC (Weighted average cost of capital
Weighted Average Cost of Capital (WACC) –
Company cost of capital = Weighted average of debtand equity returns.
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[ ] [ ]WACC = x (1 - Tc)r + x r DV debt
EV equity
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WACC
• The Weighted Average Cost of Capital (WACC) isgiven by:
• It is because interest expense is tax-deductible thatwe multiply the last term by (1 – TC)
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r WACC =
Equity + Debt
Equity × r Equity +
Equity + Debt
Debt × r Debt × (1 – T C )
r WACC = S + B
S× r S + S + B
B× r B × (1 – T C )
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WACC (Cont.)
• Taxes are an important consideration in thecompany cost of capital because interestpayments are deducted from income before
tax is calculated.
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WACC (Cont.)
Three Steps to Calculating Cost of Capital
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1. Calculate the weight of eachfinancing sourse as a proportion of thefirm’s market value.
2. Determine the required rate ofreturn on each security (financingsource).
3. Calculate a weighted average ofthese required returns (WACC).
[ ] [ ]WACC = x (1 - Tc)r + x r DV debt
EV equity
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WACC (Cont.)
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Example - continuedStep 1
Firm Value = 4 + 2 + 6 = $12 milStep 2
Required returns are givenStep 3
[ ] ( ) ( )WACC = x(1-.35).06 + x.12 + x.18=.123 or 12.3%
412
212
612
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Measuring Capital Structure
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• In estimating WACC, do not use the Book
Value of securities.
• In estimating WACC, use the Market Value ofthe securities.
• Book Values often do not represent the truemarket value of a firm’s securities.
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Measuring Capital Structure (Cont.)
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Market Value of Bonds - PV of all couponsand par value discounted at the current
interest rate.
Market Value of Equity - Market price per
share multiplied by the number ofoutstanding shares.
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Measuring Capital Structure (Cont.)
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If the long term bonds pay an8% coupon and mature in 12
years, what is their marketvalue assuming a 9% YTM?
Big Oil Book Value Balance Sheet (mil)Bank Debt 200$ 25.0%LT Bonds 200$ 25.0%Common Stock 100$ 12.5%
Retained Earnings 300$ 37.5%Total 800$ 100%
70.185$09.1
216....09.1
1609.1
1609.1
161232 PV
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Measuring Capital Structure (Cont.)
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Big Oil MARKET Value Balance Sheet (mil)Bank Debt (mil) 200.0$ 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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Cost of Capital
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Cost of Capital - The returnthe firm’s investors could
expect to earn if theyinvested in the securities
having comparable degreesof risk.
Cost of equity
Cost ofpreferred stock
Cost of debts(bank loans)
Cost of debts(bonds)
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The Cost of Equity
• From the firm’s perspective, using CAPM to estimate theexpected return that is the Cost of Equity Capital:
• To estimate a firm’s cost of equity capital, we need to knowthree things:
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)( F M i F i R R β R R -
1. The risk-free rate, R F
F M R R - 2. The market risk premium,
2 ,
) (
) , (
M
M i
M
M i i σ
σ
R Var
R R Cov β 3. The company beta,
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The Cost of Equity - Example
• Suppose the stock of Stansfield Enterprises, a publisher ofPowerPoint presentations, has a beta of 2.5. Assume a risk-free rate of 5-percent and a market risk premium of 10-percent.
• What is the appropriate discount rate for an expansion ofthis firm?
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)( F M
i F R R
β R R -
% 10 5 . 2 % 5 R
% 30 R
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Cost of equity (Cont.)
Dividend Discount Model Cost of EquityPerpetuity Growth Model =
solve for r e
P =Div
r - g01
e
r =Div
P + ge 1
0
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Cost of preferred stocks
Expected Return on Preferred StockPrice of Preferred Stock =
solve for preferred
P =Div
r 0
1
preferred
r = DivP preferred
1
0
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Cost of debts
Bonds r = YTMd
Bank loans: interest rate banks charge
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The Firm versus the Project
• Any project’s cost of capital depends on theuse to which the capital is being put —not thesource, meaning that take risk into account
• Therefore, it depends on the r i sk o f thepro jec t and not the risk of the c o m p a n y .
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Relationship Between Risk & ExpectedReturn
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E x p e c t e
d r e t u r n
b
) ( β F M i F i R R R R -
F R 1.0
M R Security market line
(SML)
CAPM - Theory of the relationship between risk and return whichstates that the expected risk premium on any security equals its
beta times the market risk premium.
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Capital Budgeting & Project Risk (Cont.)
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Project IRR
Project’s risk ( b)
17%
1.3 2.00.6
r = 4% + 0.6 ×(14% – 4% ) = 10%10% reflects the opportunity cost of capital on an investment in
electrical generation, given the unique risk of the project.
10%
24% Investments in harddrives or auto retailingshould have higherdiscount rates.
SML
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Capital Budgeting & Project Risk (Cont.)
A firm that uses one discount rate for all projects may overtime increase the risk of the firm while decreasing its value.
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P r o
j e c t I R R
Firm’s risk (beta)
SML
r f
b FIRM
Incorrectly rejected positive NPV projects
Incorrectly acceptednegative NPV projects
WACC )( F M FIRM F R R β R -
The SML can tell us why:
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Capital Budgeting & Project Risk (Cont.)
An all-equity firm should accept a project whose IRR exceedsthe cost of equity capital and reject projects whose IRRs fallshort of the cost of capital.
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P r o
j e c t
I R R
Firm’s risk (beta)
SML
5%
Good project
Bad project
30%
2.5
A
B
C
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Estimating IP’s Cost of Capital (WACC)
• The industry average beta is 0.82; the risk free rateis 8% and the market risk premium is 8.4%.
• Thus the cost of equity capital is
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r S = R F + b i × ( R M – R F )
= 3% + 0.82 ×8.4%= 9.89%
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Estimating IP’s Cost of Capital (WACC)
• The yield on the company’s debt is 8% and the firm is in the37% marginal tax rate.
• The debt to value ratio is 32%
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8.34% is International’s cost of capital. It should be used todiscount any project where one believes that the project’s risk isequal to the risk of the firm as a whole, and the project has the
same leverage as the firm as a whole
= 0.68 × 9.89% + 0.32 × 8% × (1 – 0.37)
= 8.34%
r WACC = S + BS × r S + S + BB × r B × (1 – T C )