MBA 643 Managerial Finance Lecture 9: Weighted Average Cost of Capital

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MBA 643Managerial FinanceLecture 9 Weighted
Average Cost of Capital

• Spring 2006
• Jim Hsieh

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Introduction

• From the NPV rule, we accept the project when its
  NPVgt0
• But how do we get r?
• Cost of Capital The return the firms investors
  could expect to earn if they invested in
  securities with comparable risk.
• Firms have different types of investors.

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Components of Cost of Capital

• Capital Structure The firms mix of long-term
  debt financing (D) and equity financing (E).
• Balance Sheet Model (Market Value) A D E It
  represents the claims for debtholders and
  stockholders.
• Various Components of Cost of Capital
• Cost of Debt (rD)
• Cost of Preferred Stock (rpreferred)
• Cost of Common Stock (rE)
• Usually we put cost of preferred stock with cost
  of debt.

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Weighted Average Cost of Capital

• Question If a firm has both debt and equity
  capital, how can we determine its overall cost of
  capital?
• Answer A firms overall cost of capital should
  reflect the required rate of return on the firms
  assets as a whole.
• It is a mixture of the returns required to
  compensate its creditors and stockholders.
• Definition The weighted average cost of capital
  (WACC) is the expected rate of return on a
  portfolio of all firms securities.
• Company overall cost of capital weighted
  average of debt and equity returns

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Estimating WACC -- from A D E

• Case 1 If the firm pays no tax,
• rA WACC (Total dollar return)/(Initial
  investments)
• (DrD ErE)/V
• (D/V)rD (E/V)rE wDrD wErE
• Case 2 If the firm pays tax,
• Interest payments are deducted from income before
  tax is calculated.
• After-tax cost of debt (pre-tax cost of
  debt)(1-tax rate)
• rD(1-TC) where TC corporate
  marginal tax rate
• WACC (D/V)rD(1-TC) (E/V)rE wDrD(1-TC)
  wErE

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Example 1

• FinPro Inc. has issued debt and common stock. The
  market values of these securities are 5mm and
  8mm, respectively. Given that the company pays
  7 for debt and 12 for equity, what is the WACC
  for FinPro? The company has a marginal tax rate
  equal to 40.
• WACC wDrD(1-TC) wErE
• (5/13)0.07(1-0.4)(8/13)0.12 0.09

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Estimating rD, rE, and rpreferred (recap)

• Cost of debt rD YTM(1-TC)
• Cost of preferred stock
• Since we know P0 Div1/r for preferred stock,
  rpreferred Div1/P0
• Cost of equity
• Approach 1 From SML rE rf ?(rm rf)
• Approach 2 From DDM P0 Div1/(rE - g) gt rE
  Div1/P0 g