Session 6

Session 6 • Cost of Capital

COST OF CAPITAL • WEIGHTED AVG COST OF CAPITAL (WACC) • r = wdrd + were • wd = proportion of assets funded by debt • rd = After-tax cost of debt • we = proportion of assets funded by equity • re = cost of equity

COST OF CAPITAL WACC = 40(.10)+10(.15)+50(.18) = 4 + 1.50 + 9 = 14.50% • rd = 10% rp = 15% re = 18% • wd = 40% wp = 10% we = 50% • Proof: Firm raises $100 -- Buys an Asset • Asset earns $14.50: • Debt: $40 @ 10% = $ 4.00 • Prefs: $10 @ 15% = $ 1.50 • Equity: $50 @ 18% = $ 9.00 • Total $14.50

COST OF CAPITAL • WEIGHTS: • BOOK VALUE • MARKET VALUE • TARGET • COSTS: • HISTORIC • CURRENT (MARGINAL)

Cost Of Debt • ESTIMATING COSTS • DEBT: BANK RATE • YIELD TO MATURITY ON BONDS • Example: 10 year 8% coupon bond is trading at $951 • Yield to maturity is 8.75% • [N=20; PV=-951; Pmt=40; FV=1000]

Cost Of Equity • Capital Asset Pricing Model • rf = Risk Free Rate •  = Relative Risk of Firm • Mkt Prem = Risk Premium Paid on Average Company • = rmkt - rf re = rf +  (Mkt Premium)

Cost of Equity: Components • Risk Free Rate: • 10-year Treasury Bond Rate • 3-Month Treasury Bill Rate • Market Premium: • Historic Average of 7% to 8% • Growth in economy plus inflation: 5% to 6%

Example: Boeing • Book Value % . • Debt 17,032 61% • Equity 10,825 39% • 27,857 100% • Mkt Value % . • Debt 17,032 30% • Equity 40,205 70% • (837.6*48)57,237 100%

COST OF CAPITAL • Debt: Bond Rate: 9.73% • rd = 9.73 * (1-0.34) = 6.42% • CAPM: re = rf + (Mkt Premium) • = 5.50 + 0.935(5.00) • = 5.50 + 4.68 • = 10.18%

BOEING’S WACC • BV Weights • WACC = .61*6.42 + .39*10.18 • = 3.92 + 3.97 • = 7.89% • MV Weights • WACC = .30*6.42 + .70*10.18 • = 01.93 + 7.13 • = 9.05%

Boeing Case: Changing Debt • Target Cap Structure: 60% Debt, 40% Equity • WACC = .6*6.42) + .4(10.18) • = 3.85 + 4.07 • = 7.92%

Effect of Debt on the WACC

FINANCIAL STRUCTURE

LEVERAGE

Effect of Leverage on Beta • asset = unlevered = WE* equity • tgt = asset / WE;tgt • port = w11 + w22 + w33

Boeing Case: Beta Effect • Target Cap Structure: 60% Debt, 40% Equity • asset = unlevered = (WE)* equity • = .70*.935 • = .655 • tgt = asset / (WE)tgt • = .655/.40 • = 1.64

BA Case: Beta Effect(contd.) • re = rf + (Mkt Premium) • = 5.5 + 1.64(5) • = 5.5 + 8.2 • = 13.7% • WACC = .60(6.42) + .40(13.7) • = 3.85 + 5.48 • = 9.33%

BA Case: Debt Cost Effect • re = rf + (Mkt Premium) • = 5.5 + 1.64(5) • = 13.7% • rd = 13.5 * (1-.34) = 8.91% • WACC = .60(8.91) + .40(13.7) • = 5.35 + 5.48 • = 10.83%

EFFECT OF FIN STRUCTURE ON WACC

Plot of Boeing’s WACC

Boeing’s WACC

Notes on WACC Computations • 1) Equity versus entity approach • 2) Peer group analysis – industry versus company betas. • 3) Leveraged and unleveraged betas. • 4) F: Flexibility • R: Risk • I: Income • C: Control • T: Taxes

Observations on Financial Structure • 1)You can make a lot more money by smart investment decisions (real assets) than by smart financing decisions. • 2)It is very hard to guess direction of the markets. • 3)Exotic securities of value only if you are first in the queue. And then you better know what you are doing!

Observations on Financial Structure • 4)Think about distress costs. These are less important (i.e. you can have more debt) if: • Tangible assets • Lower growth • Lower R & D • Less Reliance advertising

Observations on Financial Structure • 5)Consider impact on firm of: • Employee losses • Customer defections • Lost opportunities (NPV > 0 projects foregone) • Slower investment • R & D • Advertising • Refurbishment/Replacement • Technology

Session 6

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