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Chapter 12

Determining
the Cost of
Capital

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Chapter Outline
12. 1 A First Look at the Weighted Average Cost of
Capital
12.2 The Firms Costs of Debt and Equity Capital
12.3 A Second Look at the Weighted Average Cost of
Capital
12.4 Using the WACC to Value a Project
12.5 Project-Based Costs of Capital
12.6 When Raising External Capital Is Costly
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12-2

Learning Objectives
Understand the drivers of the firms overall cost of capital.

Measure the costs of debt, preferred stock, and common stock.


Compute a firms overall, or weighted average, cost of capital.

Apply the weighted average cost of capital to value projects.


Adjust the cost of capital for the risk associated with the project.
Account for the direct costs of raising external capital.

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12-3

12.1 A First Look at the Weighted


Average Cost of Capital
A firms sources of financing, which usually consist of debt and
equity, represent its capital.
The relative proportions of debt, equity, and other securities that
a firm has outstanding constitute its capital structure.
When corporations raise funds from outside investors, they must
choose which type of security to issue. The most common
choices are financing through equity alone and financing through
a combination of debt and equity.

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12-4

Figure 12.1 A Balance Sheet

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12-5

Figure 12.1 Two Capital Structures

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12-6

12.1 A First Look at the Weighted


Average Cost of Capital
Intuitively, the firms overall cost of capital
should be a blend of the costs of the different
sources of capital.
In fact, we calculate the firms overall cost of
capital as a weighted average of its equity and
debt costs of capital, known as the firms
weighted average cost of capital (WACC).

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12-7

Weights
What should the weights be?
Owning the firm is like owning a portfolio of its equity and debt
The expected return on the firm is therefore a weighted average,

where the weights are current market values

We use the market-value balance sheet, where the assets


(debt and equity) are all listed in terms of their market
values, instead of their book values.
Market Value of Equity + Market Value of Debt =
Market Value of Assets
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12-8

Market Value of Assets


The market-value balance sheet must still
balance:
Market Value of Equity + Market Value of Debt =
Market Value of Assets

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(Eq. 12.1)

12-9

Weighted Average Cost of Capital


Calculations
Unlevered: a firm that does not have debt
outstanding.
Levered: a firm that has debt outstanding.
Leverage: relative amount of debt on a firms
balance sheet.

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12-10

Unlevered Firm
If a firm is unlevered, it has no debt
all of the free cash flows generated by its assets are
ultimately paid out to its equity holders
Because the free cash flows to the equity holders are
the same as the free cash flows from the assets, the
Valuation Principle tells us that the market value, risk,
and cost of capital for the firms equity are equal to the
corresponding amounts for its assets.
Given this relationship, we can estimate the firms
equity cost of capital using the Capital Asset Pricing
Model (CAPM).
The resulting estimate is the cost of capital for the firm
as a whole.
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12-11

Weighted Average Cost of Capital


(Pre-tax)
Because the return of a portfolio is equal to the weighted average of the
returns of the securities in it, this equality implies the following relationship
between the required returns (costs) of equity, debt, and assets:

(Eq. 12.2)

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12-12

Example 12.1 Calculating the


Weights in the WACC
Problem:
Suppose Sony Corporation has debt with a
market value of $12 billion outstanding, and
common stock with a market value of $49
billion and a book value of $30 billion. Which
weights should Sony use in calculating its
WACC?

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12-13

Example 12.1 Calculating the


Weights in the WACC
Solution:
Plan:
Equation 12.2 tells us that the weights are the fractions
of Sony financed with debt and financed with equity.
Furthermore, these weights should be based on
market values because the cost of capital is based on
investors current assessment of the value of the
firm, not their assessment of accounting-based book
values. As a consequence, we can ignore the book value
of equity.
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12-14

Example 12.1 Calculating the


Weights in the WACC
Execute:
Given its $12 billion in debt and $49 billion in equity,
the total value of the firm is $61 billion. The weights
are:
$12 billion
$49 billion
$61 billion = 19.7 % debt $61 billion= 80.3% equity

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12-15

Example 12.1 Calculating the


Weights in the WACC
Evaluate:
When calculating its overall cost of capital,
Sony will use a weighted average of the cost of
its debt capital and the cost of its equity capital,
giving a weight of 19.7% to its cost of debt and
a weight of 80.3% to its cost of equity.

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12-16

Example 12.1a Calculating the


Weights in the WACC
Problem:
Suppose McDonalds Inc. has debt with a market
value of $18 billion outstanding, and a with a
common stock market value of $52 billion, and
a book value of $36 billion. Which weights
should McDonalds use in calculation of its
WACC?

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12-17

Example 12.1a Calculating the


Weights in the WACC
Solution:
Plan:
Equation 12.2 tells us that the weights are the fractions
of McDonalds assets financed with debt and financed
with equity. We know these weights should be based on
market values because the cost of capital is based on
investors current assessment of the value of the firm,
not their assessment of accounting-based book values.
As a consequence, we can ignore the book value of
equity.

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12-18

Example 12.1a Calculating the


Weights in the WACC
Execute:
Given its $18 billion in debt and $52 billion in equity,
the total value of the firm is $70 billion.
$18 billion
$52 billion
$70 billion = 25.7% debt $70 billion= 74.3% equity

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12-19

Example 12.1a Calculating the


Weights in the WACC
Evaluate:
When calculating its overall cost of capital,
McDonalds will use a weighted average of the
cost of its debt capital and the cost of its equity
capital, giving a weight of 25.7% to its cost of
debt and a weight of 74.3% to its cost of equity.

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12-20

Cost of Debt and Effective Cost of Debt


A firms cost of debt is the interest rate rD it would have to pay to
refinance its existing debt, such as through new bond issues.
Existing debt trades in the marketplace, so its price fluctuates to
reflect both changes in the overall credit environment and
changes in the risk specifically associated with the firm.
In the case of debt, the return paid to the debt holders is not the
same as the cost to the firm. The difference arises because
interest paid on debt is a tax-deductible expense. The effective
cost of debt is rD (1 TC)

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12-21

Example 12.2 Effective Cost of Debt


Problem:
The yield to maturity on Alcoas debt or its pretax cost of debt is 6.09%. If Alcoas tax rate is
35%, what is its effective cost of debt?

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12-22

Example 12.2 Effective Cost of Debt


Solution:
Plan:
We can use Eq. 12.3 to calculate Alcoas effective cost
of debt: rD(1 - TC).
rD = 6.09% (pre-tax cost of debt)
TC = 35% (corporate tax rate

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12-23

Example 12.2 Effective Cost of Debt


Execute:
Alcoas effective cost of debt is
0.0609 (1 0.35) = 0.039585 = 3.9585%.

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12-24

Example 12.2 Effective Cost of Debt


Evaluate:
For every $1000 it borrows, Alcoa pays its bondholders
0.0609($1000) = $60.90 in interest every year.
Every dollar in interest saves Alcoa 35 cents in taxes,
so the interest tax deduction reduces the firms tax
payment to the government by 0.35($60.90) = $21.315.
Thus Alcoas net cost of debt is the $60.90 it pays
minus the $21.315 in reduced tax payments, which is
$39.9585 per $1000 or 3.9585%.

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12-25

Example 12.2a Effective Cost of Debt


Problem:
By using yield to maturity on Gap Inc.s debt,
we find that its pre-tax cost of debt is 7.13%. If
Gap Inc.s tax rate is 40%, what is its effective
cost of debt?

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12-26

Example 12.2a Effective Cost of Debt


Solution:
Plan:
We can use Eq. 12.3 to calculate GAPs effective cost
of debt:
rD =7.13%% (pre-tax cost of debt)
TC =40% (corporate tax rate)

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12-27

Example 12.2a Effective Cost of Debt


Execute:
Gap Inc.s effective cost of debt is
0.0713 (10.40)= .0428 = 4.28%

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12-28

Example 12.2a Effective Cost of Debt


Evaluate:
For every $1000 it borrows, Gap Inc. pays its bondholders
0.0713($1000) = $71.30 in interest every year. Because it can
deduct that $71.30 in interest from its income, every dollar in
interest saves Gap Inc. 40 cents in taxes, so the interest tax
deduction reduces the firms tax payment to the government by
0.40($71.30) =$28.52. Thus Gap Inc.s net cost of debt is the
$71.30 it pays minus the $28.52 in reduced tax payments, which
is $42.78 per $1,000 or 4.28%.

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12-29

Cost of Preferred Stock


Firms may also raise capital by issuing preferred stock.

Holders of the preferred stock are promised a fixed dividend,


which must be paid in preference to (i.e., before) any
dividends can be paid to common stockholders.
Cost of Preferred Stock Capital = Preferred Dividend
Preferred Stock Price
Alcoas preferred stock has a price of $54.50 and an annual
dividend of $3.75. Its cost of preferred stock, therefore, is
3.75/54.50 = 6.8807%.

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12-30

Cost of Common Stock Capital


One way to estimate a company's cost of equity is the CAPM

Cost of Equity rf E Rmarket rf


For Alcoa, we have rE = 4.5% + 2.055% = 14.75%
Another way to estimate a companys cost of equity comes from
the Constant Dividend Growth Model (CDGM) introduced in
Chapter 9. Rather than looking backward at historical growth, one
common approach is to use estimates produced by stock analysts,
as these estimates are forward-looking.
(Eq. 12.5)

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12-31

Table 12.1 Estimating the Cost of Equity

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12-32

Example 12.3 Estimating the Cost of


Equity
Problem:
The equity beta for Weyerhaeuser (WY) is 1.2. The
yield on 10-year treasuries is 4.5%, and you estimate
the market risk premium to be 5%. Further,
Weyerhaeuser issue an annual dividend of $2. Its
current stock price is $71, and you expect dividends to
increase at a constant rate of 4% per year. Estimate
Weyerhaeusers cost of equity in two ways.

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12-33

Example 12.3 Estimating the Cost of


Equity
Solution:
Plan:

The two ways to estimate Weyerhaeusers cost of equity are to


use the CAPM and the CDGM.
1.

2.

The CAPM requires the risk-free rate, an estimate of the equitys


beta, and an estimate of the market risk premium. We can use the
yield on 10-year Treasury bills as the risk-free rate.
The CDGM requires the current stock price, the expected dividend
next year, and an estimate of the constant future growth rate for
the dividend.

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12-34

Example 12.3 Estimating the Cost of


Equity
Solution:
Plan (contd):
Risk-free rate: 4.5%
Equity beta: 1.2
Market risk premium: 5%

Current price: $71


Expected dividend: $2
Estimated future dividend
growth rate: 4%
We can use the CAPM from Chapter 11 to estimate the cost of
equity using the CAPM approach and Eq. 12.5 to estimate it
using the CDGM approach.

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12-35

Example 12.3 Estimating the Cost of


Equity
Execute:
The CAPM says that
Cost of Equity = Risk-Free Rate Equity Beta Market Risk Premium
4.5% + 1.2(5%) = 10.5%

The CDGM says


Cost of Equity

Dividend (in one year)


$2
Dividend Growth Rate
4% 6.8%
Current Price
$71

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12-36

Example 12.3 Estimating the Cost of


Equity
Evaluate:

According to the CAPM, the cost of equity capital is 10.5%;


the CDGM produces a result of 6.8%.

Because of the different assumptions we make when using


each method, the two methods do not have to produce the
same answer--in fact, it would be highly unlikely that they
would.

When the two approaches produce different answers, we must


examine the assumptions we made for each approach and
decide which set of assumptions are more realistic.

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12-37

Example 12.3 Estimating the Cost of


Equity
Evaluate (contd):
We can also see what assumptions about future dividend
growth would be necessary to make the answers
converge. By rearranging the CDGM and using the cost
of equity we estimated from the CAPM, we have
Dividend (in one year)
Current Price
10.5% 2.8% 7.7%

Dividend Growth Rate Cost of Equity

Thus, if we believe that Weyerhaeusers dividends will


grow at a rate of 7.7% per year, the two approaches would
produce the same cost of equity estimate.

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12-38

Example 12.3a Estimating the Cost of


Equity
Problem:
The equity beta for Harley-Davidson (HOG) is 2.3.
The yield on 10-year treasuries is 2.0%, and you
estimate the market risk premium to be 4.5%. Further,
HOG issues an annual dividend of $0.40. Its current
stock price is $23.76, and you expect dividends to
increase at a constant rate of 6.0% per year. Estimate
HOGs cost of equity in two ways.

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12-39

Example 12.3a Estimating the Cost of


Equity
Solution:
Plan:
The two ways to estimate HOGs cost of equity are to
use the CAPM and the CDGM.
1.

2.

The CAPM requires the risk-free rate, an estimate of the equitys


beta, and an estimate of the market risk premium. We can use the
yield on 10-year Treasury bills as the risk-free rate.
The CDGM requires the current stock price, the expected dividend
next year, and an estimate of the constant future growth rate for
the dividend.

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12-40

Example 12.3a Estimating the Cost of


Equity
Solution:
Plan (contd):
Risk-free rate: 2.0%
Equity beta: 2.3
Market risk premium: 4.5%

Current price: $23.76


Expected dividend: $0.40
Estimated future dividend
growth rate: 6.0%
We can use the CAPM from Chapter 11 to estimate the cost of
equity using the CAPM approach and Eq. 12.5 to estimate it
using the CDGM approach.

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12-41

Example 12.3a Estimating the Cost of


Equity
Execute:
The CAPM says that
Costof equity Risk freerate EquityBeta MarketRiskPremium
2.0% 2.3 4.5%12.35%

The CDGM says that


Dividend(inoneyear)
DividendGrowthRate
Current Price
0.40

6.0% 1.68% 6.0% 7.68%


23.76

Cost of equity

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12-42

Example 12.3a Estimating the Cost of


Equity
Evaluate:
According to the CAPM, the cost of equity capital is 12.35%; the
CDGM produces a result of 7.68%. Because of the different
assumptions we make when using each method, the two methods
do not have to produce the same answer in fact, it would be
highly unlikely that they would. When the two approaches
produce different answers, we must examine the assumptions we
made for each approach and decide which set of assumptions is
more realistic.

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12-43

Example 12.3a Estimating the Cost of


Equity
Evaluate:
We can also see what assumption about future dividend growth
would be necessary to make the answers converge. By
rearranging the CDGM and using the cost of equity we estimated
from the CAPM, we have
Dividend (inone year )
Current Pr ice
12.35% 1.68% 10.67%

Dividend Growth Rate Cost of Equity

Thus, if we believe that Harley-Davidsons dividends will grow


at a rate of 10.67% per year, the two approaches would produce
the same cost of equity estimate.
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12-44

Weighted Average Cost of Capital


rwacc = rEE% + rpfd P% + rD(1 TC)D%
(Eq. 12.6)

For a company that does not have preferred


stock, the WACC condenses to:
rwacc = rEE% + rD(1 TC)D%

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(Eq. 12.7)

12-45

Computing the WACC for Alcoa


We computed rD = 6.09%, rE = 14.75%, and rP =
6.8807%
Market values ($millions) are 31,420 for
common stock, 40 for preferred stock, and 7,397
for debt .Total is 38,857 .Total is 38,857 .Total is
38,857.
31, 420
40
7,397
WACC 14.75%

6.8807%

6.09%
1

0.35

38,857

38,857

38,857
12.69%
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12-46

Example 12.4 Computing the WACC


Problem:
The expected return on Targets equity is 11.5%,
and the firm has a yield to maturity on its debt of
6%. Debt accounts for 18% and equity for 82%
of Targets total market value. If its tax rate is
35%, what is this firms WACC?

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12-47

Example 12.4 Computing the WACC


Solution:
Plan:
We can compute the WACC using Eq. 12.7. To
do so, we need to know the costs of equity and
debt, their proportions in Targets capital
structure, and the firms tax rate. We have all
that information, so we are ready to proceed.

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12-48

Example 12.4 Computing the WACC


Execute:

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12-49

Example 12.4 Computing the WACC


Evaluate:
Even though we cannot observe the expected return of
Targets investments directly, we can use the expected
return on its equity and debt and the WACC formula to
estimate it, adjusting for the tax advantage of debt.
Target needs to earn at least a 10.1% return on its
investment in current and new stores to satisfy both its
debt and equity holders.

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12-50

Example 12.4a Computing the WACC


Problem:
The expected return on Macys equity is 10.8%,
and the firm has a yield to maturity on its debt of
8%. Debt accounts for 16% and equity for 84%
of Macys total market value. If its tax rate is
40%, what is this firms WACC?

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12-51

Example 12.4a Computing the WACC


Solution:
Plan:
We can compute the WACC using Eq. 12.7. To
do so, we need to know the costs of equity and
debt, their proportions in Macys capital
structure, and the firms tax rate. We have all
that information, so we are ready to proceed.

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12-52

Example 12.4a Computing the WACC


Execute:
rwacc = rEE% + rD (1 TC)D%
= (0.108)(0.84) + (0.08)(1 0.40)(0.16)
= .0984 or 9.84%

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12-53

Example 12.4a Computing the WACC


Evaluate:
Even though we cannot observe the expected return of
Macys investments directly, we can use the expected
return on its equity and debt and the WACC formula to
estimate it, adjusting for the tax advantage of debt.
Macys needs to earn at least a 9.84% return on its
investment in current and new stores to satisfy both its
debt and equity holders.

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12-54

Figure 12.3 WACCs for Real Companies

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12-55

Adjustments Made in Practice


To avoid the confounding effects of excess cash on the balance
sheet, practitioners often use net debt instead of debt in
calculating the debt percentage.
Net Debt is Debt less Cash
Market values: (Net Debt) =Debt (Cash and Risk-Free
Securities)
because cash flows from debt (interest paid) cancel cash flows
from holding cash (interest received).
Net debt is often used instead of Debt in computing weights for
WACC

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12-56

Risk-Free Interest Rate


Estimating the equity cost of capital using the CAPM requires
the risk-free interest rate. The risk-free interest rate is generally
determined using the yields of U.S. Treasury securities, which
are free from default risk.
The Market Risk Premium. Using the CAPM also requires an
estimate of the market risk premium. As mentioned in Chapter
10, one way to estimate the market risk premium is to look at
historical data. Because we are interested in the future market
risk premium, we face a tradeoff in terms of the amount of data
we use.

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12-57

Table 12.2 Risk-Free Securities

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12-58

12.4 Using the WACC to Value a Project

A projects cost of capital depends on its risk. When the market


risk of the project is similar to the average market risk of the
firms investments, then its cost of capital is equivalent to the
cost of capital for a portfolio of all the firms securities.
Because the WACC incorporates the tax savings from debt, we
can compute the value of an investment including the benefit of
the interest tax deduction given the firms leverage policy,
sometimes called the investments levered value. To do so, we
discount the firms future incremental free cash flow using the
WACC, a process we refer to as the WACC method

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12-59

Example 12.5 The WACC Method


Problem:
Suppose Anheuser Busch is considering introducing a
new ultra-light beer with zero calories to be called
BudZero. The firm believes that the beers flavor and
appeal to calorie-conscious drinkers will make it a
success.
The risk of the project is judged to be similar to the risk
of the company.
The cost of bringing the beer to market is $200 million,
but Anheuser Busch expects first-year incremental free
cash flows from BudZero to be $100 million and to
grow at 3% per year thereafter.
Should Anheuser Busch go ahead with the project?
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12-60

Example 12.5 The WACC Method


Solution:
Plan:
We can use the WACC method shown in Eq.
12.9 to value BudZero and then subtract the
upfront cost of $200 million.We will need
Anheuser Buschs WACC, which was estimated
in Figure 12.3 as 5.7%.

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12-61

Example 12.5 The WACC Method

Execute:
The cash flows for BudZero are a growing
perpetuity. Applying the growing perpetuity
formula with the WACC method, we have:

Growing Perpetuity: A valuation of an income stream where annual payments grow as well as having the
investment meets a required rate of return of the investment. These growing payments continue forever, "in
perpetuity".
Value of a growing Perpetuity:
Annual payment / (Required rate of return - Annual Payment Growth Rate)
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12-62

Example 12.5 The WACC Method


Evaluate:
The BudZero project has a positive NPV because it is
expected to generate a return on the $200 million far in
excess of Anheuser Buschs WACC of 5.7%.
Taking positive-NPV projects adds value to the firm.
Here, we can see that the value is created by exceeding
the required return of the firms investors.

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12-63

Example 12.5a The WACC Method


Problem:
Suppose Starbucks is considering introducing a new
Caff Mocha with zero calories to be called Caff
Mucho. The firm believes that the coffees flavor and
appeal to calorie-conscious coffee drinkers will make it
a success. The risk of the project is judged to be similar
to the risk of the company. The cost of bringing the
Caff Mucho to market is $280 million, but Starbucks
expects first-year incremental free cash flows from
Caff Mucho to be $80 million and to grow at 5% per
year thereafter. Should Starbucks go ahead with the
project?
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12-64

Example 12.5a The WACC Method


Solution:
Plan:
We can use the WACC method shown in Eq.
12.9 to value Caff Mucho and then subtract the
upfront cost of $280 million. We will need
Starbucks WACC, which was estimated in
Figure 12.3 as 7.4%.

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12-65

Example 12.5a The WACC Method


Execute:
The cash flows for Caff Mucho are a growing
perpetuity. Applying the growing perpetuity
formula with the WACC method, we have:
V0L FCF0

FCF1
$80 million
280
$3,053.33million($3.05billion)
rWACC g
.074 .05

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12-66

Example 12.5a The WACC Method


Evaluate:
The Caf Mucho project has a positive NPV because it
is expected to generate a return on the $280 million far
in excess of Starbucks WACC of 7.4%. As discussed
in Chapter 3, taking positive-NPV projects adds value
to the firm. Here, we can see that the value is created by
exceeding the required return of the firms investors.

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12-67

Key Assumptions of WACC


Assumption 1:
Average Risk. We assume initially that the market risk
of the project is equivalent to the average market risk of
the firms investments.
In that case, we assess the projects cost of capital
based on the risk of the firm.

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12-68

Key Assumptions of WACC


Assumption 2:
Constant Debt-Equity Ratio. We assume that the firm
adjusts its leverage continuously to maintain a constant
ratio of the market value of debt to the market value of
equitya relationship referred to as the debt-equity
ratio.
This policy determines the amount of debt the firm will
take on when it accepts a new project.
It also implies that the risk of the firms equity and debt,
and therefore its WACC, will not fluctuate owing to
leverage changes.
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12-69

Key Assumptions of WACC


Assumption 3:
Limited Leverage Effects. We assume initially that the
main effect of leverage on valuation follows from the
interest tax deduction.
We assume that any other factors (such as possible
financial distress) are not significant at the level of debt
chosen.

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12-70

Table 12.3 Expected Free Cash Flow

NPV of FCF at Alcoa's WACC of 12.69% is $28.54 million,


assuming that the market risk of the project is similar to the
market risk of Alcoa's business.
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Example 12.6 A Project in a New Line


of Business

Problem:
You are working for Cisco evaluating the possibility of selling
digital video recorders (DVRs). Ciscos WACC is 13.3%. DVRs
would be a new line of business for Cisco, however, so the
systematic risk of this business would likely differ from the
systematic risk of Ciscos current business.
As a result, the assets of this new business should have a
different cost of capital. You need to find the cost of capital for
the DVR business. Assuming that the risk-free rate is 4.5% and
the market risk premium is 5%, how would you estimate the cost
of capital for this type of investment?

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Example 12.6 A Project in a New Line


of Business
Solution:
Plan:
The first step is to identify a company operating in Ciscos targeted
line of business. TiVo, Inc., is a well-known marketer of DVRs. In
fact, that is all TiVo does.
Thus the cost of capital for TiVo would be a good estimate of the cost
of capital for Ciscos proposed DVR business. Many Web sites are
available that provide betas for traded stocks, including
http://finance.yahoo.com.
Suppose you visit that site and find that the beta of TiVo stock is 2.9.
With this beta, the riskfree rate, and the market risk premium, you can
use the CAPM to estimate the cost of equity for TiVo. Fortunately for
us, TiVo has no debt, so its cost of equity is the same as its cost of
capital for its assets.
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Example 12.6 A Project in a New Line


of Business
Execute:
Using the CAPM, we have:

Because TiVo has no debt, its WACC is equivalent to


its cost of equity.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

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Example 12.6 A Project in a New Line


of Business
Evaluate:
The correct cost of capital for evaluating a DVR
investment opportunity is 19%.
If we had used the 13.3% cost of capital that is
associated with Ciscos existing business, we would
have mistakenly used too low of a cost of capital.
That could lead us to go ahead with the investment,
even though it truly had a negative NPV.

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Example 12.6a A Project in a New Line


of Business
Problem:
You are working for H.J. Heinz Company evaluating the
possibility of selling a beverage. Heinz WACC is 6.6%.
Beverages would be a new line of business for Heinz, however,
so the systematic risk of this business would likely differ from
the systematic risk of Heinz current business. As a result, the
assets of this new business should have a different cost of
capital. You need to find the cost of capital for the beverage
business. Assuming that the risk-free rate is 3.0% and the market
risk premium is 5.4%, how would you estimate the cost of
capital for this type of investment?

Copyright 2009 Pearson Prentice Hall. All rights reserved.

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Example 12.6a A Project in a New Line


of Business
Solution:
Plan:
The first step is to identify a company operating in Heinz targeted line
of business. Coca-Cola Company is a well-known marketer of
beverages. In fact, that is almost all Coca-Cola does. Thus the cost of
capital for Coca-Cola would be a good estimate of the cost of capital
for Heinz proposed beverage business. Many Web sites are available
that provide company betas, including http://finance.yahoo.com.
Suppose you visit that site and find that the beta of Coca-Cola is 0.4.
With this beta, the risk-free rate, and the market risk premium, you can
use the CAPM to estimate the cost of equity for Coca-Cola. Coca-Cola
has a market value debt/assets ratio of .58, and (according to
http://finra.org) its cost of debt is 3.8%. Its tax rate is 28%.
Copyright 2009 Pearson Prentice Hall. All rights reserved.

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Example 12.6a A Project in a New Line


of Business
Execute:
Using the CAPM, we have:
Coca Cola ' scost of equity Risk freerate Coca Cola ' sbeta Market Risk Premium
3% .4 5.4% 5.8%

To get Coca-Colas WACC, we use equation 12.6.


Coca-Cola has no preferred stock, so the WACC is:
rWACC rE E% rD (1 TC )D%
5.8%(0.42) 3.8%(1 .28)(0.58) 4.02%
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Example 12.6a A Project in a New Line


of Business
Evaluate:
The correct cost of capital for evaluating a beverage
investment opportunity is 4.02%. If we had used the
6.6% cost of capital that is associated with Heinz
existing business, we would have mistakenly used too
high of a cost of capital. That could lead us to reject the
investment, even if it truly had a positive NPV.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

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12.5 Project-Based Capital Costs


Up to this point we have assumed that both the risk and
the leverage of the project under consideration matched
those characteristics for the firm as a whole. This
assumption allowed us, in turn, to assume that the cost
of capital for a project matched the firms cost of
capital.
Evaluate Cost of Capital for a New Acquisition
Divisional Cost of Capital
Firms with more than one division rarely use a single

companywide WACC to evaluate projects.

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12.6 When Raising External Capital Is Costly


We have assumed that we can raise external capital
without any extra costs associated with the capitalraising transaction. As a consequence, we had no
reason to treat a project financed with new external
funds any differently than a project financed with
internal funds (retained earnings).
In reality, issuing new equity or bonds carries a number
of costs.
Treat the issuing costs as what they arecash outflows
that are necessary to the project. We can then
incorporate this additional cost as a negative cash flow
in the NPV analysis.
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Example 12.7 Costly External Financing

Problem:
You are analyzing Alcoas potential acquisition of
Weyerhaeuser. Alcoa plans to offer $23 billion as the purchase
price for Weyerhaeuser, and it will need to issue additional debt
and equity to finance such a large acquisition.
You estimate that the issuance costs will be $800 million and
will be paid as soon as the transaction closes.
You estimate the incremental free cash flows from the
acquisition will be $1.4 billion in the first year and will grow at
3% per year thereafter.
What is the NPV of the proposed acquisition?
Copyright 2009 Pearson Prentice Hall. All rights reserved.

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Example 12.7 Costly External Financing


Solution:
Plan
We know from Section 12.5 that the correct cost of capital for this acquisition
is Weyerhaeusers WACC. We can value the incremental free cash flows as a
growing perpetuity:

The NPV of the transaction, including the costly external financing, is the
present value of this growing perpetuity net of both the purchase cost and the
transaction costs of using external financing.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

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Example 12.7 Costly External Financing


Execute:
Noting that $800 million is $0.8 billion,:

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Example 12.7 Costly External Financing


Evaluate:
It is not necessary to try to adjust Weyerhaeusers
WACC for the issuance costs of debt and equity.
Instead, we can subtract the issuance costs from the
NPV of the acquisition to confirm that the acquisition
remains a positive-NPV project even if it must be
financed externally.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

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Example 12.7a Costly External


Financing
Problem:
You are analyzing Microsofts potential acquisition of Yahoo! in
February of 2008. Microsoft plans to offer $44.6 billion as the
purchase price for Yahoo!, and it will need to issue additional
debt and equity to finance such a large acquisition. You estimate
that the issuance costs will be $1.5 billion and will be paid as
soon as the transaction closes. You estimate the incremental free
cash flows from the acquisition will be $1.8 billion in the first
year and will grow at 3% per year thereafter. What is the NPV of
the proposed acquisition?

Copyright 2009 Pearson Prentice Hall. All rights reserved.

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Example 12.7a Costly External


Financing
Solution:
Plan
We know from Section 12.5 that the correct cost of capital for this acquisition
is Yahoo!s WACC. We can value the incremental free cash flows as a
growing perpetuity:
PV CF1 (r g)
where
CF1 $1.8 billion
r Yahoo!' s WACC 7.1%
g 3%

The NPV of the transaction, including the costly external financing, is the
present value of this growing perpetuity net of both the purchase cost and the
transaction costs of using external financing.
Copyright 2009 Pearson Prentice Hall. All rights reserved.

12-87

Example 12.7a Costly External


Financing
Execute:
NPV $44.6 1.5

Copyright 2009 Pearson Prentice Hall. All rights reserved.

1.8
$2.2 billion
0.071 .03

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Example 12.7a Costly External


Financing
Evaluate:
It is not necessary to try to adjust Yahoo!s WACC for
the issuance costs of debt and equity. Instead, we can
subtract the issuance costs from the NPV of the
acquisition to see that the acquisition is a negative-NPV
project.

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Summary of WACC Method


To summarize, the key steps in the WACC valuation method are as follows:
1. Determine the incremental free cash flow of the investment.
2. Compute the weighted average cost of capital using Eq. 12.6.
3. Compute the value of the investment, including the tax benefit of leverage, by

discounting the incremental free cash flow of the investment using the WACC.

In many firms, the corporate treasurer performs the second step, calculating
the firms WACC. This rate can then be used throughout the firm as the
companywide cost of capital for new investments that are of comparable risk
to the rest of the firm and that will not alter the firms debt-equity ratio.
Employing the WACC method in this way is very simple and straightforward.
As a result, this method is the most commonly used in practice for capital
budgeting purposes.

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Chapter Quiz
Why do we use market value weights in the weighted
average cost of capital??
How can you measure a firms cost of debt?
What are the major tradeoffs in using the CAPM versus
the CDGM to estimate the cost of equity?
Why do different companies have different WACCs?
What inputs do you need to be ready to apply the
WACC method?

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