MFIN1021 Chapter Notes - Chapter 13: Weighted Arithmetic Mean, Capital Structure

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11 Jun 2018

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Chapter 13

Formulas:

Weighted Average Cost of Capital = (Debt/Total x (1 - Tax Rate) rdebt) + (Equity/Total x requity),

Total = Debt + Equity

WACC = (Debt/Total x (1 - Tax Rate) rdebt) + (Preferred/Total x rpreferred) (Equity/Total x requity),

Total = Debt + Equity + Preferred

requity = DIV1/P0 + growth (based on the constant-growth formula)

rpreferred = Dividend/Price of Preferred

Definitions:

Capital Structure: the mix of long-term debt and equity financing

Weighted-Average Cost of Capital (WACC): the expected rate of return on a portfolio of all

the firm’s securities, adjusted for tax savings due to interest payments. The company cost of

capital is a weighted average of the returns demanded by debt and equity investors. The

weighted average is the expected rate of return investors would demand on a portfolio of all the

firm’s outstanding securities.

Rules:

Calculating WACC

1. Calculate the value of each security as a proportion of firm value

2. Determine the required rate of return on each security

3. Calculate a weighted average of the after-tax return on the debt and the return on equity

The weighted-average cost of capital is the rate of return that the firm must expect to

earn on its average-risk investments in order to provide an adequate expected return to

all its security holders. The weighted-average cost of capital is an appropriate discount

rate only for a project that is a carbon copy of the firm’s existing business. But often it is

used as a companywide benchmark discount rate; the benchmark may be adjusted

upward for unusually risky projects and downward for unusually safe ones.

When Corporate Tax Rate is Not Zero

● the weighted-average cost of capital is the right discount rate for average-risk

capital investments

● the weighted average cost of capital is the return the company needs to earn after

tax in order to satisfy all its security holders

● if the firm increases its debt ratio, both the debt and the equity will become more

risky. The debtholders and equityholders require a higher return to compensate

for increased risk

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Document Summary

Weighted average cost of capital = (debt/total x (1 - tax rate) rdebt) + (equity/total x requity), Wacc = (debt/total x (1 - tax rate) rdebt) + (preferred/total x rpreferred) (equity/total x requity), Total = debt + equity + preferred requity = div1/p0 + growth (based on the constant-growth formula) rpreferred = dividend/price of preferred. Capital structure: the mix of long-term debt and equity financing. Weighted-average cost of capital (wacc): the expected rate of return on a portfolio of all the firm"s securities, adjusted for tax savings due to interest payments. The company cost of capital is a weighted average of the returns demanded by debt and equity investors. The weighted average is the expected rate of return investors would demand on a portfolio of all the firm"s outstanding securities.

Related Questions

I need help proof reading my assignment please, thank you in advance.

Cost of Debt

The cost of debt is the effective rate that a company pays on its total debt.

As a company acquires debt through various bonds, loans and other forms of debt, the cost of debt is a useful metric. It gives an idea as to the overall rate being paid by the company to use debt financing. This measure is also useful because it gives investors an idea as to the riskiness of the company compared with others. The higher the cost of debt, the higher the risk.

1. Cost of debt (before tax) = Corporate Bond rate of companyâs bond rating.

Pepsico 2.75% = 2.75%

Current cost of Debt as of February 17th 2014 = 2.75%

2. Current tax rate

In 2013 PepsiCoâs tax rate was = 23.66%

2013 PepsiCo averaged tax rate of 23.66%

3. Cost of Debt (After Tax) = (Cost of Debt Before Tax) (1 â Tax Rate)

The effective rate that a company pays on its current debt after tax.

.0275 x (1 â .2366) = Cost of debt after tax

The cost of debt after tax for PepsiCo is 2.10%

Cost of Equity or R Equity = Risk Free Rate + Beta Equity (Average Market Return â Risk Free Rate)

The cost of equity is the return a firm theoretically pays to its equity investors to compensate for the risk they undertake by investing in their company.

Risk Free Rate = U.S. 10-year bond = 2.74%

Average Market Return 1950 â 2014 = 7%

Beta = PepsiCoâs Beta = 0.37

Risk Free Rate + Beta Equity (Average Market Return â Risk Free Rate)

2.74 + 0.37 (7- 2.74)

2.74 + 0.37 x 4.26

2.74 + 1.58 = 4.31%

Currently, PepsiCoâs has a Cost of Equity or R Equity of 4.31%, so investors should expect to get a return of 4.31% per-year average over the long term on their investment to compensate for the risk they undertake by investing in this company.

Weighted Average Cost of Capital or WACC calculation

The WACC calculation is a calculation of a companyâs cost of capital in which each category of capital is equally weighted. All capital sources such as common stock, preferred stock, bonds and all other long-term debt are included in this calculation.

As the WACC of a firm increases, and the beta and rate of return on equity increases, this is an indicator of a decrease in valuation and a higher risk. By taking the weighted average, we can see how much interest the company has to pay for every dollar it finances. For this calculation, you will need to know the following listed below:

Tax Rate = 23.66%

Cost of Debt (before tax) or R debt = 2.75%

Cost of Equity or R equity = 4.31%

Debt (Total Liabilities) for 2013 TTM or D = $53.069 billion

Stock Price = $78.09 (Feb. 17th, 2014)

Outstanding Shares = 1.55 billion

Equity = Stock price x Outstanding Shares or E = $121.04 billion

Debt + Equity or D+E = $174.109 billion

WACC = R = (1 â Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 â Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 â .2366) x .0275 x ($53.069 /$174.109) + .0431 ($121.04 /$174.109)

.7634x .0275 x .3048 + .0431 x .6972

.0064 + .03

= 3.64%

Based on the calculations above, we can conclude that PepsiCo pays 3.64% on every dollar that it finances, or 3.64% cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0673 plus the cost of the investment for the investment to be feasible for the company.

Understanding the WACC of a company is important because securities analysts employ WACC all the time when valuing and selecting investments. In discounted cash flow analysis, for instance, WACC is used as the discount rate applied to future cash flows for deriving a businessâs net present value.

Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. Letâs say a company produces a return of 20% and has a WACC of 11%. That means that for every dollar the company invests into capital, the company is creating nine cents of value. By contrast, if the companyâs return is less than WACC, the company is shedding value, which indicates that investors should put their money elsewhere.

Part I. Given the tax rate of 40% of this corporation, calculate its after-tax weighted average cost of capital (WACC) for Duke Corporation.

Table: the before-tax weighted average cost of capital (WACC) for Duke Corporation

Source of Capital	Weight (1)	Cost (2)	Weighted Cost (1) X (2)
Long-Term Debt	.4	5.6%	2.24%
Preferred Stock	.1	10.6%	1.06%
Common Stock Equity	.5	13%	6.5%
Totals	1		9.8%

Part II. Answer true, false or uncertain and explain briefly on the following statement. "the after-tax wacc cannot ever be higher than the before-tax wacc."

What is an appropriate required rate of return (hurdle rate) for Food Products and Instruments? How did you get it? (Hints: you may want to use the capital asset pricing model (CAPM) to estimate the cost of equity)

Chestnut Foods Estimation of WACC for Chestnut Foods (year-end 2013) Chestnut Foods Hurdle Rate as of December 2013: 7.0% Chestnut uses a hurdle rate that reflects prevailing rates of return in financial markets using a weighted average of both debt and equity securities. The current mix of debt and equity in Chestnutâs capital structure on a market-value basis is 20% debt and 80% equity. The prevailing yield on debt of similar credit risk is estimated at 3.5%. Based on a marginal corporate tax rate of 37%, the after-tax cost of debt is 2.2%. The cost of equity for Chestnut is estimated at 8.2% based on the CAPM with a beta of 0.9, a market risk premium of 6.0%, and a risk-free rate of 2.8%.* Based on these estimates, the WACC is 7.0%. * An alternative model that uses a market risk premium of 9% and a risk-free rate of 0.1% gives a similar cost-of-equity estimate. PLEASE CLARIFY HOW TO GET D/E RATIOS. `WACC Food Processing market risk premium 9% risk-free rate 0.1% debt ratio 60% equity ratio 40% tax rate 37% cost of debt 2.20% cost of equity 4.8% WACC 3.22%

Instruments market risk premium 9% risk-free rate 0.1% debt ratio 40% equity ratio 60% tax rate 37% cost of debt 2.20% cost of equity 9.4% WACC 6.52%

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MFIN1021 Chapter Notes - Chapter 13: Weighted Arithmetic Mean, Capital Structure

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