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Cost of Capital Wacc • Assumptions - Optimal Capital Structure capital structure is not changing overtime NPV = -0 + Σ (1 + ) ValueFirm = Σ (1 + ) Free Cash Flows to Firm • FCF These are the cash flows to be paid to all capital suppliers ignoring interest rate payments (i.e., as if the project(firm) were 100% equity financed). FCF = EBIT(1-tc) +D -Δnoncash NWC - CAPEX Cost of Capital “The cost of capital of an asset depends primarily on the risk of that asset The cost of capital is asset-specific Formula = (1 − tc) + + + = (1 − ) + Optimal Capital Structure Weights Cost of Debt Before Tax Cost of Debt : →It reflects the return that debt-holders require on their investment (YTM) or the risk-free rate plus a default spread given actual debt rating → The cost of debt is mainly determined by two factors - Current level of interest rates - Rating of the company (if available) Cost of Debt (cont’d) If you do not have ratings for the debt. There are alternatives: → Use the rate at which it can borrow from local banks → Estimate the YTM on a portfolio of bonds with similar credit ratings and maturity. Cost of Debt (cont’d) Marginal Tax Rate : tc →It’s the marginal tax rate of the firm Cost of Common Equity • Cost of Common Equity Capital : The cost of equity is the return that equity investors require on their investment. The main approach to estimate the cost of equity is to use a risk model (CAPM, APT, Gordon…) We will focus on the CAPM: = Rf + β ( E(RM ) − Rf ) Risk free rate • Use short term government rate • Use long term government rate • What if the government is not a default-free entity or does not issue long term bonds? find the rate at which the largest and safest corporations can borrow long-term and reduce the rate by a small default premium (i.e., 0.3%). Market Risk Premium (MRP) • The MRP in the CAPM is the difference between the return of the market portfolio and the risk-free rate • In general, the MRP →is greater than zero (risk aversion) →increases with the risk aversion of the investors • The risk premium may change over time Risk Premium (cont’d) Estimating the Market Risk Premium Methods: • Estimate the implied premium in today’s asset prices • Estimate the market risk premium using historical data Risk Premium (cont’d) HISTORICAL Market RISK PREMIUMS FOR THE US MARKET Arithm. 1928-2017 1968-2017 2008-2017 [Mkt - T.Bill ] 8.09 6.58 9.85 [Mkt - T.Bonds] 6.1 4.24 5.98 Beta Two approaches to estimate the Beta: 1. Beta estimate based on βS of comparable firms 2. Estimation based on Historical Market data Return on Stock vs Mkt (like SP500) Beta? • If βi > 1 more risky than the market If βi = 2 Stock i fluctuates twice as much as the market • If βi < 1 less risky than the market If βi=.5 • If βi =1 Capital Structure Weights Leverage Ratio + should be the target capital structure (in MV) + for the particular asset under consideration • Market Value of Debt is more difficult to estimate because few firms have only publicly traded debt There are solutions: →Assume book value of debt is equal to market value →Estimate the market value of debt from the book value Capital Structure Weights (cont’d) Equity Ratio + • Market Value of Equity →Share price * Shares outstanding • Assume book value of equity is equal to market value If firm(project/division) is not publicly traded debt Capital Structure Weights (cont’d) Common mistakes → Use 100% debt if Asset is all debt financed → Use 100% Equity if Asset is all equity financed → Using of the firm undertaking the + project(division) when the risk is different Example General Electric’s businesses: →Power systems →Aircraft engines →Industrial →Engineered plastics →Technical products →Appliances →Broadcasting Multidivisional firms should calculate a different WACC for each division ? Vive la difference • If the risk of the project(division) # risk of the firm, use cost of capital of the project (division) use comparable firms (Pure Play) to estimate cost of equity Pure Play - Find similar risk firms (N firms) that are publicly traded - Get Beta (βL) for each firm and plug it in βL(i)= βU(i) (1+(1-tc) D/E(i)) - N firms [βU (1) , , …., βU (N) ] - Compute The average βUnlevered βU = Σi βU(i) /N i =1,2….N Hamada Model Pure Play (cont’d) - Compute βSL of the project(division) using its own leverage ratio βL = βU (1+ (1-tc) D/E) - Compute of the project = Rf + β L MRP Note Preferred stock Using the preferred dividend and observed price of preferred stock, = = (1 − tc) + + + + ++ + +