The Weighted Average Cost of Capital
and
Company Valuation
Chapter 13
Fundamentals of Corporate Finance
2012 Linköpings universitet
1
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1917 bildades Finanskoncernen Kreuger & Toll
Svenska Tändsticks AB, 1930 omfattade 60 % av
världens tändsticksproduktion.
Kreuger & Toll Pris föll från sin högsta notering i
mars 1929 på över 46 dollar till 4,5 dollar i slutet av
1931
 1929 depression, och han fick likviditetskris
 Dock hans imperium blev grunden för många
svenska koncernen.

Ivar Kreuger omkring 1930 vid sitt skrivbord i
Tändstickspalatset
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Cost of Capital
Weighted Average Cost of Capital (WACC)
Measuring Capital Structure
Calculating Required Rates of Return
Calculating WACC
Interpreting WACC
Valuing Entire Businesses
3
Most companies are financed by a mixture of
securities. Including common stock, bonds,
and other securities. These securities have
different risks, therefore investors require
different return on them.
Cost of Capital – required rate of return on
investment.
It is the return the firm’s investors could expect
to earn if they invested in other equally risky
securities.
4
Capital Structure - The firm’s mix of debt
financing and equity financing.
Long term capital structure involves only long
term debt and equity
Market value of debt and market value of
equity corresponds to the market capital
structure. This is to differentiate from
the book value of debt and equity.
5

Taxes are an important consideration in the
company cost of capital, because interest payments
are tax deductible.
After tax cost of debt = pretax cost x (1 - tax rate)
= rdebt x (1 -  )
6
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.
Company cost of capital = Weighted average of debt
and equity returns.
7
Weighted Average Cost of Capital = WACC
 D
  E

WACC = 
 (1 -  )rdebt  + 
 requity 
D  E
 D  E

8
Three Steps to Calculating Cost of Capital
1. Calculate the proportion of firm´s debt and
equity.
2. Determine the required rate of return on
equity and debt.
3. Calculate a weighted average after tax return
on the debt and equity.
9
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital?
Market Value Debt
Market Value Equity
Market Value Assets
$194
30%
$453 70%
$647 100%
10
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital?
WACC = (.3  8%) + (.7 14%) = 12.2%
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Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital?
Portfolio Return = (.3  8%) + (.7 14%) = 12.2%
Interest is tax deductible. Given a 35% tax rate, debt only
costs us 5.2% (i.e. 8 % x .65).
WACC = (.3  5.2%) + (.7 14%) = 11.4%
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rassets =
total income
valueof investments

D rdebt + E requity
D E
rassets   1 -  rdebt    r
D
V
E
V equity

13
Weighted Average Cost of Capital with debt,
equity and Preferred Stock
Preferred stock provides a specific dividend
that is paid before any dividends are paid to
common stock.
D
 E
 P

WACC =   (1 -  )rdebt  +   requity  +   rPreferred 
V
 V
 V

Where D is the value of debt, E is the value of equity, P is
preferred stock, τ is tax rate.
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Example - Executive Fruit has issued debt, preferred
stock and common stock. The market value of these
securities are $4mil, $2mil, and $6mil, respectively.
The required returns are 6%, 12%, and 18%,
respectively.
Q: Determine the WACC for Executive Fruit, Inc.
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Example - continued
Step 1
Firm Value = 4 + 2 + 6 = $12 mil
Step 2
Required returns are given
Step 3
6
4
  2

0.18
WACC = 
(1 - 0.35)0.06  + 
0.12  +
12
  12
 12
= 0.123 or 12.3%
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Market Value of Bonds – Present Value of
all coupons and par value discounted at the
current yield to maturity, YTM.
Market Value of Equity - Market price per
share multiplied by the number of
outstanding shares.
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Page 374/5 Example: Suppose Long term bond has a coupon
payment of 8%, 12 year to maturity.
Common stocks 100 million shares valued at 12 $ each
Book Value of Big Oil´s Debt and Equity (mil)
Bank Debt
$
200
25,0%
LongTerm Bonds $
200
25,0%
Common Stock
$
100
12,5%
Retained Earnings $
300
37,5%
Total
$
800
100%
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If the long term bonds pay an 8% coupon
and mature in 12 years, market interest rate
is 9%, what is the market value of the bonds?
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16
16
216
PV 


 .... 
2
3
12
1.09 1.09 1.09
1.09
 $185.70
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Big Oil MARKET Value Debt and Equity (mil)
Bank Debt (mil)
$ 200,0
12,6%
LT Bonds
$ 185,7
11,7%
Total Debt
$ 385,7
24,3%
Common Stock
$ 1 200,0
75,7%
Total
$ 1 585,7
100,0%
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On Bonds
rd = YTM
On Common Stock
re = CAPM
= rf +  i (rm - rf )
That is, expected return on stock is equal to risk free return plus beta times
market risk premium.
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Dividend Discount Model (DDM)
Constant Dividend Growth Model =
Div1
P0 =
re - g
solve for re
Div1
re =
+ g
P0
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Expected Return on Preferred Stock
Price of Preferred Stock =
P0 =
solve for preferred
Div
rpreferred
rpreferred
Div
=
P0
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Amazon.com
Ford
Newmont Mining
Intel
Microsoft
Dell Computer
Boeing
McDonalds
Pfizer
Dupont
Disney
ExxonMobil
IBM
Wal-Mart
Campbell Soup
GE
Heinz
Expected
return
Interest rate Proportion of Proportion of
on equity (%) on debt (%) Equity (E/V) Debt (D/V) WACC (%) Mkt Cap Totl debt
19.8
7.3
0.96
0.04
19.3
33.8
1.2
20.2
7.7
0.07
0.93
6.1
12.2
163.2
8.9
6.5
0.89
0.11
8.4
24.2
3.0
14.1
5.8
0.98
0.02
13.9
111.2
2.0
10.3
na
1.00
0.00
10.3
311.7
0.0
11.9
6.0
0.99
0.01
11.8
47.8
0.7
11.6
5.8
0.88
0.12
10.7
62.4
8.6
13.1
5.9
0.89
0.11
12.1
62.5
7.8
7.7
5.3
0.95
0.05
7.5
159.3
8.7
11.7
6.0
0.81
0.19
10.2
38.9
9.0
10.0
6.0
0.78
0.22
8.7
55.5
15.5
8.7
5.3
1.00
0.00
8.7
465.0
0.0
10.9
5.8
0.80
0.20
9.5
140.7
35.3
4.7
5.7
0.80
0.20
4.5
190.0
47.4
6.2
6.0
0.82
0.18
5.8
12.6
2.8
8.3
5.3
0.41
0.59
5.4
344.0
491.0
7.1
6.7
0.73
0.27
6.4
14.3
5.3
Notes: 1. Expected return on equity is taken from Table 12-2
2. Interest rate on debt is calculated from yields on similarly rated bonds
3. D is the book value of the firm's debt,and E is the market value of
equity
4. WACC = (1 - .35) x rdebt x (D/V) + requity x (E/V)
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The WACC is an appropriate discount rate
only for a project that is the same of the
firm's existing business
There are two costs of debt financing. The
explicit cost of debt is the rate of interest
bondholders demand. The implicit cost is the
increased required return from equity due to
increased bankruptcy probability.
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Issues in Using WACC
Debt has two costs.
1)return on debt and
2)increased cost of equity demanded due to the increase in risk
of bankruptcy
 Betas may change with capital structure
 assets =  1 -   debt  +   equity 
D
V

E
V
Corporate taxes complicate the analysis and may change our
decision
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Free Cash flow is cash flow that is available to
investors,
FCF= operating cash flow - investment
expenditures.
 FCF is a more accurate measurement of PV than
either Dividend or Earnings per share EPS.
 Free Cash Flows (FCF) should be the theoretical basis
for all PV calculations.
 When valuing a business for purchase, always use
FCF.
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Valuing a Business
 The value of a business or project is usually computed as
the discounted value of FCF out to a valuation horizon
(H).

The valuation horizon is sometimes called the
terminal value and is calculated like present value
of growth opportunity (PVGO).
FCF1
FCF2
FCFH
PVH
PV 

 ... 

1
2
H
(1  WACC ) (1  WACC )
(1  WACC )
(1  WACC ) H
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
Valuing a Business or Project
PV 
FCF1
FCF2
FCFH
PVH


...


(1  WACC )1 (1  WACC ) 2
(1  WACC ) H (1  WACC ) H
PV (free cash flows)
PV (horizon value)
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See P 382/3, Example - Concatenator
Manufacturing, cash flows are provided as
follows: y1=-73,6 y2=-87,1 y3=-102,9 Y4=-34,1 y5=40,2 y6=79,5
with a discount rate 8,5%, and a steady growth of 5% from year 5
onwards.
 79.5 
Horizon Value  
  2,271.40
 .085  .05 
73.6
87.1
102.9
34.1
40.2
2,271.40
PV(FCF)  




2
3
4
5
1.085 1.085 1.085 1.085 1.085 1.0855
 1,290.40
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