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MBA 643 Managerial Finance Lecture 9: Weighted Average Cost of Capital

MBA 643 Managerial Finance Lecture 9: Weighted Average Cost of Capital. Spring 2006 Jim Hsieh. Introduction. From the NPV rule, we accept the project when its NPV>0: But how do we get “r”?

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MBA 643 Managerial Finance Lecture 9: Weighted Average Cost of Capital

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  1. MBA 643Managerial FinanceLecture 9: Weighted Average Cost of Capital Spring 2006 Jim Hsieh

  2. Introduction • From the NPV rule, we accept the project when its NPV>0: • But how do we get “r”? • Cost of Capital: The return the firm’s investors could expect to earn if they invested in securities with comparable risk. • Firms have different types of investors.

  3. Components of Cost of Capital • Capital Structure: The firm’s mix of long-term debt financing (D) and equity financing (E). • Balance Sheet Model (Market Value): A = D + E: It represents the claims for debtholders and stockholders. • Various Components of Cost of Capital: • Cost of Debt (rD) • Cost of Preferred Stock (rpreferred) • Cost of Common Stock (rE) • Usually we put cost of preferred stock with cost of debt.

  4. Weighted Average Cost of Capital • Question: If a firm has both debt and equity capital, how can we determine its overall cost of capital? • Answer: A firm’s overall cost of capital should reflect the required rate of return on the firm’s assets as a whole. • It is a mixture of the returns required to compensate its creditors and stockholders. • Definition: The weighted average cost of capital (WACC) is the expected rate of return on a portfolio of all firm’s securities. • Company overall cost of capital = weighted average of debt and equity returns

  5. Estimating WACC -- from A = D + E • Case 1: If the firm pays no tax, rA = WACC = (Total dollar return)/(Initial investments) = (D*rD + E*rE)/V = (D/V)*rD + (E/V)*rE = wDrD + wErE • Case 2: If the firm pays tax, • Interest payments are deducted from income before tax is calculated. • After-tax cost of debt = (pre-tax cost of debt)*(1-tax rate) =rD(1-TC) where TC = corporate marginal tax rate WACC = (D/V)*rD*(1-TC) + (E/V)*rE = wDrD(1-TC) + wErE

  6. Example 1 • FinPro Inc. has issued debt and common stock. The market values of these securities are $5mm and $8mm, respectively. Given that the company pays 7% for debt and 12% for equity, what is the WACC for FinPro? The company has a marginal tax rate equal to 40%. WACC = wD*rD*(1-TC) + wE*rE = (5/13)*0.07*(1-0.4)+(8/13)*0.12 = 0.09

  7. Estimating rD, rE, and rpreferred (recap) • Cost of debt = rD = YTM*(1-TC) • Cost of preferred stock: • Since we know P0 = Div1/r for preferred stock, rpreferred = Div1/P0 • Cost of equity: • Approach 1: From SML: rE = rf + (rm – rf) • Approach 2: From DDM: P0 = Div1/(rE - g) => rE = Div1/P0 + g

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