Lecture 11

WACC, Kp & Valuation Methods

Investment Analysis

WACC

• A company’s WACC is calculated in 3 steps:

1. Determine the proportionate weighting of each source of capital financing based on their market values.

2. Calculate the after-tax rate of return (cost) of each source.

3. Calculate the weighted average cost of all sources.

Investment Analysis

WACC (cont’d …)

• The traditional formula used to develop WACC is:

WACC = (ke x We) + (kp x Wp) + (kd/(pt)[1-t] x Wd)

Where:WACC = Weighted average cost of capitalke = Cost of common equity capitalWe = % of common equity in the capital structure at market valuekp = Cost of preferred equityWp = % of preferred equity in the capital structure at market valuekd/(pt) = Cost of debt(pretax)t = Tax rateWd = % of debt in the capital structure at market value

Investment Analysis

Cost of Debt “kd”• The cost of debt measures the current cost to the firm of borrowing funds

to finance projects. In general terms, it is determined by the following variables:

1. The riskless rate: As the riskless rate increases, the cost of debt for firms will also increase

2. The default risk of the company: As the default risk of a firm increases, the cost of borrowing money will also increase

3. The tax advantage associated with debt: Since interest is tax deductible, the after-tax cost of debt is a function of the tax rate. The tax benefit that accrues from paying interest makes the after-tax cost of debt lower than the pre-tax cost. Furthermore, this benefit increases as the tax rate increases.

After-tax cost of debt = Pre-tax cost of debt (1-tax rate)

Investment Analysis

Market Value of Debt

• The market value of debt is usually more difficult to obtain directly, since very few firms have all their debt in the form of bonds outstanding trading in the market. Many firms have non-traded debt, such as bank debt, which is specified in book value terms but not market value terms.

• A simple way to convert book value debt into market value debt is to treat the entire debt on the books as one coupon bond, with a coupon set equal to the interest expenses on all the debt and the maturity set equal to face-value weighted average maturity of the debt, and then to value this coupon bond at the current cost of debt for the company.

Investment Analysis

Market Value of Debt (cont’d …)

• The market value of $ 1 billion in debt, with interest expenses of $ 60 million and a maturity of 6 years, when the current cost of debt is 7.5% can be estimated as:

1 1 – 1.0756 1,000

Estimated market value of debt = 60 + = $ 930 million 0.075 1.0756

Investment Analysis

Cost of Preferred Stock “kp”

• Preferred stocks have some of the characteristics of debt – the preferred dividend is pre-specified at the time of the issue and is paid out before common dividend and some of the characteristics of equity – the payments of preferred dividend are not tax deductible.

• If preferred stock is viewed as perpetual, the cost of preferred stock can be written as follows:

Preferred Dividend per sharekp =

Market price per preferred share

Investment Analysis

Cost of Preferred Stock (cont’d …)

• This approach assumes the dividend is constant in dollar terms forever and that the preferred stock has no special features (convertibility etc).

• If such special features exist, they will have to be valued separately to estimate the cost of preferred stock. In terms of risk, preferred stock is safer than common equity because preferred dividends are paid before dividends on common equity. It is, however, riskier than debt since interest payments on debt are made prior to preferred dividend payments.

• Consequently, on a pre-tax basis, it should command a higher cost than debt and a lower cost than equity.

Investment Analysis

Calculating kp

• In March 1995, General Motors had preferred stock that paid a dividend of $2.28 annually and traded at $26.38 per share. The cost of preferred stock can be estimated as:Preferred dividend per share 2.28

Kp = = = 8.64% Market price per preferred share 26.38

• At the same time, GM’s ke, using CAPM was 13%, its pre-tax kd was 8.25% and its after-tax kd was 5.28%. Not surprisingly, its preferred stock was less expensive than equity but more expensive than debt.

Investment Analysis

Valuation Methods/Approaches

1. Income Based Valuation– Dividend Discount Models– Free Cash Flow Models

• FCFE• FCFF

– Residual Income Models2. Market Based Valuation

– P/E ratio– P/B ratio– P/S ratio– P/CF ratio– EV/EBITDA ratio– Dividend Yield ratio– Justified ratios( justified versions of all of the above ratios)

3. Asset Based Valuation

Investment Analysis

Income/Cash Flow Based Valuation

In stock valuation models, there are 3 predominant definitions of future cash flows:

1. Dividends

2. Free Cash Flows

3. Residual Income

Investment Analysis

Dividend Discount Model (DDM)

• Dividends: DDM defines cash flows as the dividends to be received by the shareholders.

Advantages• The primary advantage of using dividends as the definition of cash flow is that

its theoretically justified. The shareholder’s investment today is worth the PV of the future cash flows he expects to receive, and ultimately he will be repaid for his investment in the form of dividends. Even if the investor sells the stock at any time prior the liquidation of the company, before all the dividends are paid, he will receive from the buyer of the shares the PV of the expected future dividends.

• An additional advantage of dividends as a measure of cash flow is that dividends are less volatile than other measures (earnings or free cash flows), and therefore, the value estimates derived from DDM are less volatile and reflect the long-term earning potential of the company.

Investment Analysis

DDM (cont’d …)

Disadvantages:• The primary disadvantage of dividends as a cash flow measure is that its difficult to

implement for firms that don’t currently pay dividends. It is possible to estimate expected future dividends by forecasting the point in the future when the firm is expected to begin paying dividends. The problem with this approach in practice is the uncertainty associated with forecasting the fundamental variables that influence stock price (earnings, growth rate and required return) so far into the future.

• A second disadvantage of measuring cash flows with dividends is that it takes the perspective of an investor who owns a minority stake in the firm and cannot control the dividend policy. If the dividend policy dictated by the controlling interests bears a meaningful relationship to the firm’s underlying profitability, then dividends are appropriate. However, if the dividend policy is not related to the firm’s ability to create value, then dividends are not an appropriate measure of expected future cash flow to share holders.

Investment Analysis

When to Use DDM?

• Dividends are appropriate as a measure of cash flow in the following cases:

• The company has a history of dividend payments.

• The dividend policy is clear and related to the earnings of the firm.

• The perspective is that of a minority shareholder.

Investment Analysis