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Video 31 (Topic 6.5): The Weighted Average Cost of Capital (WACC). FIN 614: Financial Management Larry Schrenk, Instructor. Topics. Determining the Weights A Complete Example Using WACC for Valuing… Internal Divisions Projects. Weighting the Sources of Capital. - PowerPoint PPT Presentation
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FIN 614: Financial Management
Larry Schrenk, Instructor
Video 31 (Topic 6.5):The Weighted Average Cost of Capital (WACC)
Topics
1. Determining the Weights
2. A Complete Example
3. Using WACC for Valuing…1. Internal Divisions2. Projects
Weighting the Sources of Capital
d c pd p s sWACC r (1– ) rw w rw
Weights represent the percentage raised by each source of financing:
d
p
s
Debtw =
Firm ValuePreferred Stock
w = Firm Value
Common Stockw =
Firm Value
Two Possible Goals:Firm as Currently FinancedWACC as Discount Rate for Project
DecisionsFirm versus Project Weights Book versus MarketPast versus FutureActual versus Target
Weighting Objectives
Factors Influencing WACC
Uncontrollable Factors:Market Conditions, especially Interest RatesMarket Risk PremiumTax Rate
Controllable Factors:Capital Structure PolicyDividend PolicyInvestment Policy
Firms with riskier projects generally have a higher cost of equity
Investment AmountsCommon Stock = $50,000
Bonds = $25,000Preferred Shares = $25,000
Bond Price = $990Coupon Rate = 8%Period = SemiannualMaturity = 25 YearsPar Value = $1,000
WACC ExamplePreferred Stock
Price = $85Dividend = $8
Common StockRisk-Free Rate (rf) = 5%Return on Market (rM) = 12%Beta (b) = 1.1
Corporate Tax Rate tc = 35%
1. Calculate Weights, wd, wp, ws
2. Calculate Cost of Equity Capital, rs, using CAPM.
3. Calculate Cost of Preferred Capital, rs, using Market Implied Discount Rate
4. Calculate Cost of Debt Capital, rd, using YTM.
5. Calculate WACC.
WACC Example Overview
WACC Example: Weights
d
p
s
Debt 25w = =
Debt + Preferred Stock + Common Stock 50 25 25Preferred Stock 25
w = = Debt + Preferred Stock + Common Stock 50 25 25
Common Stock 50w = =
Debt + Preferred Stock + Common
25%
25%
Stock 50
25 2550%
Price = $990Coupon Rate = 8%Period = SemiannualMaturity = 25 YearsPar Value = $1,000
Yield to Maturity (YTM)
N = 50; I% = 8.09%; PV = -990; PMT = -40; FV = -1,000; P/Y = 2
WACC Example: Cost of Debt
Price = $85Dividend = $8
Implied Discount Rate
WACC Example: Cost of Preferred Stock
pp
d d 8.00V =
r V 859
00%
..41r
rf = 5%rM = 12%b = 1.1
CAPM
WACC Example: Cost of Common Stock
5 1.112 5 12.70%
i f mE r r E r r
wd = 0.25; wp = 0.25; ws = 0.50rd = 8.09%rp = 9.41%rs = 12.70% tc = 35%
WACC Example: Result
d d c p p s sWACC = w r (1– ) + w r + w r
= 0.25 0.0809 1 0.35 0.25 0.0941 0.50 0.1270
= 0.0131 + 0.0235 + 0.0 16 035 = .01%
Firm WACC and its Divisions
Composite WACC reflects the risk of an average project undertaken by the firm.
Different divisions may have different risks.
The division’s WACC should be adjusted to reflect the division’s risk and capital structure.
The Risk-Adjusted Divisional Cost of Capital
Estimate the cost of capital as if division were a stand-alone firm.
Estimating the division’s beta, cost of debt, and capital structure.
Pure Play Method
Find several publicly traded companies exclusively in division’s or project’s business.
Use average of their betas as proxy for project’s beta.
Hard to find such companies.
Accounting Beta Method
Regression between project’s ROA and S&P Index ROA.
Accounting betas are correlated (0.5 – 0.6) with market betas.
Problem: Data on new projects
Divisional Cost of Capital Using CAPM
Target Debt Ratio = 10%rd = 12%rrf = 5.6%tc = 40%bdiv = 1.7Market Risk Premium = 6%
Divisional Cost of Capital Using CAPM
Division Required Return on Equity:rs = rrf + bdiv(rM – rrf)
rs = 5.6% + 1.7(6%) = 15.8%.
WACCdiv = wd rd(1 – tc) + wsrs
= 0.1(12%)(0.6) + 0.9(15.8%)= 14.94%
Division WACC vs. Firm WACC
Division WACC = 14.9% versus company WACC = 10.4%
‘Typical’ projects within this division would be accepted if their returns are above 14.9%.
The Risk and Financing of a Project
If project has same financing and risk as the existing business or assets of the firm, use WACC as our discount rate
If the new project has very different financing or risk from existing business,
WACC must be adjusted (if possible), or
Use alternate method to find discount rate
Misusing WACC for All Projects: Example
What would happen if we use the WACC for all projects regardless of risk?
Assume the WACC = 15%
Project Required Return Expected Return A 20% 17% B 15% 18% C 10% 12%
Using One WACC for All Projects
You tend to favor more risky projects
Mistakenly reject project C and take project A
In making such mistakes, the firm becomes more and more risky.
Consider the Project Financing and Risk If the project is more (less) risky than the firm, use a discount rate greater (less) than the WACC
If the project has different financing than the firm, adjust the weights
IMPORTANT: If project weights are significantly different than the firm’s, then this may change required rates of return.
FIN 614: Financial Management
Larry Schrenk, Instructor
Video 31 (Topic 6.5):The Weighted Average Cost of Capital (WACC)
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