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Corporate Finance. FINA 4330 The Weighted Average Cost of Capital Lecture 21 Fall, 2010. Cost of Capital. r s = r o + (r o -r B )B/S. WACC = r o. r. r B. Cost of Capital (After Tax). r s = r o + (r o -r B )(1-T)B/S. r. WACC = r 0 (1-T(D/v)) = r s (S/V) + r B (1-T) (B/V). r B. - PowerPoint PPT Presentation
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Corporate Finance
FINA 4330The Weighted Average Cost of Capital
Lecture 21Fall, 2010
Cost of Capital
WACC = ro
rs = ro + (ro -rB)B/S
rB
Cost of Capital (After Tax)
WACC = r0(1-T(D/v)) = rs(S/V) + rB(1-T) (B/V)
rs = ro + (ro-rB)(1-T)B/S
rB
The two ways of representing firm value
V = V (u) + T * B
V = Y(1-T) (1+WACC)t
Where, WACC = r0 = rs (S/V) + rB (1-T)(B/V)
Static Tradeoff Theorem• Costs of Financial Distress
(“Contracting Costs”)– Potential Bankruptcy Costs– Underinvestment – Risk Shifting – Agency Costs
• Assume:• Not Taxes• Risk neutrality• Single period• Interest rate = 0%
Example of Underinvestment
ASSETS
PVA $1,000,000
PVGO 2,000,000
TOTAL $3,000,000
LIABILITIES
DEBT 2,500,000
EQUITY 500,000
TOTAL $3,000,000
Example of Underinvestment
ASSETS
PVA $1,000,000
PVGO 2,000,000
TOTAL $3,000,000
LIABILITIES
DEBT 2,500,000
EQUITY 500,000
TOTAL $3,000,000
Example of Underinvestment
ASSETS
PVA $1,000,000 (Cash = 600,000) (Real Assets = 400,000)PVGO 2,000,000
TOTAL $3,000,000
LIABILITIES
DEBT 2,500,000
EQUITY 500,000
TOTAL $3,000,000
Example of Underinvestment Make a Div Payment rather than invest
ASSETS
PVA $400,000
(Real Assets = 400,000)PVGO 2,000,000
TOTAL $2,400,000
LIABILITIES
DEBT 2,250,000
EQUITY 1 50,000
TOTAL $2,400,000
Risk Shifting
• Suppose the firm has value that will look like the following:
»Value in Good State = $4,500,000»Value in Bad State = 1,500,000»With equal probability »Promised payment to the Bondholder: $3,500,000
What is the value of the equity and the debt?
Investment Opportunity
• Invest $1,000,000 to generate: $1,500,000 with probability ½ in good state, 0 otherwise, so that New cash flows are:
$5,000,000 in good state 500,000 in bad state:
What is the NPV of the project, value of the debt and value of the equity?
Costs of Financial Distress
V = V(u) + PV of Tax Shield
Firm Value
Debt LevelOptimal Debt Level
Pecking Order Hypothesis
• Costly Information
• Conclusion – Firm has an ordering under which they will
Finance• First, use internal funds• Next least risky security
Intuition
• Suppose that you know your firm is undervalued, and you want to invest in a project: How do you finance it?
• Now suppose you believe the firm is overvalued
Pecking Order theory
• So you have a dominating way of getting capital – Internal Financing – Risk free debt– Risky debt– Equity In general, the more “debt like” a security is, the
more you want to issue it.
So the announcement effect
• If the firm announces it intends to issue equity to invest in a project, this is bad news and stock prices will go down. That is the market will ASSUME this is a bad firm.
• Therefore the firm will never issue equity if it can avoid it.
• Thus pecking order.
