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Chapter 14

FNCE+2P91-Corporate+Finance-Notes-Chapter+14-Weighted+Average+Cost+of+Capital+_WACC_.docx

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Department
Finance
Course
FNCE 2P91
Professor
Clarke Melville
Semester
Winter

Description
FNCE 2P91 - Section 05 Winter 2011 - Duration 03 05.04.11 FNCE 2P91: Corporate Finance-Notes-Chapter 14: Weighted Average Cost of Capital (WACC) Notes Final  Going to be the same format as the midterm o Pretty much the same o Multiple choice and then problems o Most of it will be on material after the midterm E-mail  [email protected] o Email for questions for midterm o Or if want to use as a reference WEIGHED AVERAGE COST OF CAPITAL (WACC)  Capital structure o What is the optimal mix of debt and equity to finance the business  In this class, we are going to be looking at three different sources of financing, each is going to have a “cost” STUFF TO REMEMBER 1. Use market weights and values to determine capital structure 2. There are two approached to calculate cost of common equity 3. We are going to be dealing with floatation costs 4. Cost of debt has a tax savings component A firm raises money from a variety of sources. The WACC (Weighted Average Cost of Capital) is the cost of money for the firm as a whole. How this fits in with the capital budgeting we have been doing is, at the very least the firm wants to accept projects that have a return greater than the WACC WACC can be used for “Required Return” for NPV analysis. ( ) ( ) ( ) Example: i. Cost of Equity (Common) 1. CAPM Approach A firm’s shares’ have Beta of 1.778, expected return in market is 14%, and risk-free rate is 8%. What is cost of equity?  Use CAPM to determine an investor’s required return FNCE 2P91 - Section 05 Winter 2011 - Duration 03 ( ) 2. Dividend Discount Model Solve for “r” or return in dividend discount model ii. Preferred Shares  Same as common share dividend model but no growth with preferred shares Example: BMO is considering issuing an 8% preferred share offer with the par value of $25 and expected market price is $28. iii. Cost of Debt** ( ) **Debt interest is tax deductable FLOTATION COST  It costs money to raise money Example: A 3% underwriting commission on new common stock issuance, if a firm wanted to raise $4 million dollars for a project it is going to need to raise so that the “net proceeds” of $4 000 000. Question: WACC Example Tucker Corporation has the following capital structure: Common Shares Outstanding 7 000 000 Preferred Shares Outstanding 2 500 000 Bonds Outstanding 350 000 Bonds have a par value of $1000 with a coupon rate of 9%, years to maturity is 25 years, currently sell for $763.57, coupons are paid semi-annually. Common shares currently trade for $18.75 in the market, have a beta of 1.5. The Preferred shares sell for $28 and they currently pay an annual dividend of $4. T-bills (risk-free rate) are currently yielding 5% and expected return on the market is 12%. Ticker’s tax rate is 40%. What is Tucker’s WACC? FNCE 2P91 - Section 05 Winter 2011 - Duration 03 Answer: I. K f (Common) S ( ) II. KPf (Preferred) III. K f(Debt) D  Know: o Find YTM, Coupon rate is 9% and bonds sell at discount so YTM > 9% Try YTM = 14% ( ) [ ] ( ) But bonds sell for $763.57 so 14% is too high YTM, so try 12%. And at 12% So ( ) IV. WACC Market Weights of Firm: WEIGHT Common 28.01% Preferred 14.94% Debt 57.04% Value 100% *Use market weights for WACC. Therefore, that is what it would cost firm to raise money for new project. ( ) ( ) ( ) ( ) ( ) ( ) V. Flotation Cost Tucker Corporation wants to raise $25 000 000. Flotation Costs: Common Shares 6% Preferred Shares 8% Debt 4% Assume came capital structure as above, how much does Ticker need to raise? ( ) ( ) ( ) So Tucker needs to raise ( ) Practice Problems: 14-9, 14-15, 14-19, 14-21 FNCE 2P91 - Section 05 Winter 2011 - Duration 03 REVIEW Question: TVM A student just graduated from Brock at age 22 and want to save for retirement at age 60. The retirement plan: first deposit can be made one year from today, for the first 10 years you can save $5000 per year and then for the next 28 years you can save $10 000 per year. At age 60 you want to be able to withdraw an amount each month for 30 years. Your first withdrawal will be on your 60 birthday. If interest rates ear EAR of 8% throughout, how much can you withdraw each month? Answer: 22 23 24 25 32 33 59 60 IIIIIIIIIIII 61 89 D D D D D D WWWW 38 Deposits At 8% (
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