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Chapter 13

Chapter 13 ECON 2560.docx

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Department
Economics
Course
ECON 2560
Professor
Tahsin Mehdi
Semester
Summer

Description
Chapter 13 ECON 2560 The Weighted-Average Cost of Capital & Company Valuation Capital Structure: A firm’s mix of debt & equity financing THE WEIGHTED-AVERAGE COST OF CAPITAL  The company cost of capital is defined as the opportunity cost of capital for the firm’s existing assets  We use it to value new assets that have the same risk as the old ones  Company’s cost of capital is the minimum acceptable rate of return when the firm expands by investing in average-risk projects  When the firm invests rather than returns cash to shareholders, the shareholders lose the opportunity to invest in financial markets  The expected rates of return on investments in financial markets determine the cost of capital for corporate investments  The company cost of capital is the opp. Cost of capital for the company as a whole  The weighted-average cost of capital formula adjusts for if company raises different types of debt & equity Calculating Company Cost of Capital as a Weighted Average  Most companies issue debt as well as equity so their cost of capital depends on both the cost of debt & cost of equity  In this case the company cost of capital is a weighted average of the returns demanded by the debt & equity investors. Total Market Value (V) = Market Value Outstanding Debt (D) + Market Value Outstanding Equity (E) Company Cost of Capital = weighted average of debt & equity returns Debt holders need income of: (r debt D) Equity Investors need income of (r equity D) The total income that is needed is (r x D) + (r X D) debt equity To calculate the return needed on the assets, simply divide income by investments…. Rassets Total Income___ (rdebt D) + (requity D) = D E Value of Investment = V ( V x rdebt) + ( V x equity) Use Market Weights, Not Book Weights  Market values often differ from the values recorded by accountant in the company’s book  If investors recognize company’s excellent prospects, the market value of equity may be much higher than book value and the debt ratio will be lower when measured in terms of market values rather than book values  Financial managers use book debt-to-value ratios for various other purposes and sometimes they accidently look to the book ratios when calculating weights for the company cost of capital  This is a mistake b/c the company cost of capital measures what investors want from the company and depends on how THEY value the companies securities and that value depends on future profits & cash flows not on accounting history  Book values measure only cumulative historical outlays… they generally don’t measure market values accurately Taxes & The Weighted-Average Cost of Capital  When you calculate a projects NPV, you need to discount the cash flows AFTER tax b/c the after-tax cash flows are the relevant project cash flows  The interest payments on the debt companies are financed by are deducted from the income before tax is calculated  Therefore the cost to the company of an interest payment is reduced by the amount of this tax saving After-tax cost of debt = (1 – tax rate) x pretax cost = (1 – Tc) xdebt The Weighted-average cost of capital: Expected rate of return on a portfolio of all the firm’s securities, adjusted for tax savings due to interest payments What if there are 2 or more sources of financing?  Simply calculate the weighted-average after-tax return of each security type WACC for a firm with common stock, bonds and preferred stocks…. WACC = [ D x (1 – T )cr debt + [ P x preferred+ [ E x equity V V V CALCULATING REQUIRED RATES OF RETURN The Expected Return on Bonds  As long as the company doesn’t go belly-up, the rate of return to investors in the yield to maturity offered on the bond  If there is any chance firm won’t be able to repay the debt, the yield to maturity will be the most favorable outcome but the expected rate of return will be lower The Expected Return on Common Stock Estimates Based on the Capital Asset Pricing Model Expected return on stock = risk free interest rate + [Stock’s beta x Expected market risk premium]  To implement CAPM you need the stock’s beta, the current risk-free interest rate and an estimate of the market risk premium Estimates Based on the Dividend Discount Model  Whenever you’re given an estimate of the expected return on common stock, always look for ways to check whether it is reasonable  One check is if the cost of equity is greater than the cost of debt b/c equity of firm is riskier than any of its debt  Another check can be done using dividend discount model P = DIV ___ 0 1 requity g P0= current stock price DIV 1 the forecast dividen
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