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Risk, Return and Capital Budgeting The Hurdle Rate – The minimum rate of return that must be met for a company to undertake a particular project The Weighted Average Cost of Capital (WACC) -The hurdle rate for capital budgeting decisions -Return on the project must EXCEED return required by provides of capital rb= before tax cost of debt ri= rb(1 – Tc) = after tax cost of debt rps after tax cost of preferred shares rs– return required by shareholders w j proportion of debt, equity and preferred shares in the firm, based on market values of capital structure after financing has been raised k = rWACC= ri debt rps +ps Capital rsW equity Structure Weights W equity_S_ W debt _B_ W ps_P_ V V V S = market value of equity (Market price x number of shares) P = market value of preferred shares B = market value of debt V = value of the firm Value of the firm (V) = S + B+ + P B WACC = r b (1−Tc)( ) + rps V Assumptions -Need efficient markets -If project risk = firm overall risk, use firm WACC to evaluate the project -If project risk ≠ firm overall risk, DO NOT use the firm WACC. We should use a discount rate that matches the risk of the project -WACC is a discount rate that matches firm overall risk Ex. A firm issued bonds 10 years ago at a cost of debt = 12%. The firm currently can issue bonds at a cost of debt = 10%. Which cost of debt should be used to calculate WACC? a. 10% *Should be looking forward, NOT back b. 12% Ex. A project costs $10M. The firm borrows $10M to fund this project at a before tax cost of debt, rb = 10%. Assume no tax. Assume project risk = firm risk. Firm WACC = 14%. Which discount rate do we use to evaluate this project? a. 10% b. 14% *How a project is funded does not matter in discount rate What are Efficient Markets? -A market is efficient if prices quickly reflect all available information about the firm Ex. a) Reactive industries has the following capital structure. Its corporate tax rate is 35%. What is its WACC? Security Market Value Return required by investors Debt $20 M 8% Preferred stock $10 M 10% Equity $50 M 15% b) Passive footwear has a WACC of 12%. Its debt sells at a yield to maturity of 9%, and its tax rate is 40%. Its cost of equity is 15%. If the firm is financed by debt and common equity only, what fraction of the firrs= Div i g is financed by equity? Po −n 1−(1+rb) P = F x C rb + The Cost of Equity -The return that investors require on a stock, s Capital Asset Pricing Model (CAPM) Valuation R – R + β (r – s f m Determinants of Beta R)f -Firms whose revenues are highly cyclical have higher β -Firms that have a high degree of operating leverage have higher β -Firms with a higher degree of financial leverage have higher β s β = Covariance Ex. The Marketretention,firmretention Bedrock Corporation’s common stock has a beta of 1.4. IfVariable(marketretention) and the market risk premium is 9%, what is Bedrock’s cost of equity capital? YTM = coupon + Dividend ¿of coupon payments Valuation (face value−price) maturity ¿ ( ) -To solve for r s the firm’s cost of equity: -Growth rate is usually unknown; estimate it from past growth or use analysts’ forecasts of future growth rates Ex. The Chilton Oil Co. just issued a dividend of $3 per share on its common stock. The company is expected to maintain a constant 5% growth rate in its dividends If the stock sells for $60 a share, what is Chilton’s cost of equity? Ex. Stock in Eddy Industries has a beta of 1.2. The market risk premium is 7.5% and T-bills are currently yielding 6%. Eddy’s most recent dividend was $3.15 per share and dividends are expected to grow at a 3% annual rate indefinitely. If the stock sells for $27.50 per share, what is your best estimate of Eddy’s cost of equity? Cost of Debt -The interest is tax deductible – we call it the “interest tax shield” -Tax shield = tax savings -The interest tax shield reduces the cost of debt -ri= rb(1 – T )cis the after tax cost of new debt Ex. Consider a firm that borrows $1 million at 9%. The corporate tax rate is 40%. What is the cost of debt to this firm? Bonds F = face value of the bond (typically $1,000) n = number of years until the bond matures C = annual coupon rates rb= the NOMINAL return required by investors. Also the YTM P = the market price of the bond *To get the semi-annual, divide r by b and multiple n by 2 Bonds & Yield to Maturity -The yield to maturity is the market interest rate that equates a bond’s present value of interest payments and principal repayment with its price YTM = C  P = F Trade at par YTM > C  P < F Trade at discount YTM < C  P > F Trade at premium Ex. An investor is considering an investment in one of two bonds which have the same yield to maturity of 9%. Both bonds pay semi-annual coupons. Bond 1 has a coupon rate of 10% and 15 years to maturity. [premium] Bond 2 has a coupon rate of 8% and 25 years to maturity. [discount] Without undertaking any calculation, which bond will trade at premium? Which bond will trade at a discount? Price both bonds. rd Suppose there exists a 3 bond, bond 3. If bond 3 trades at par, what is its coupon rate? Yield to Maturity Approximation Ex. In the mid 1990’s Union Gas had an annual bond outstanding with 27 years to maturity and a coupon rate of 8.65%. The bond was currently selling for 134.58% of its face value. Union Gas’ tax rate is 35%. What is Union Gas’ (approximation) cost of debt? Ex. Armstrong Inc. is planning to issue new debt. Armstrong can currently issue debt that has an annual coupon rate of 10%, pays interest semi-annually
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