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- Portfolio Management - Chapter 7
- sapm
- Risk and Return
- Total Beta
- Contabilitate si costul capitalului
- TR09 (Rectified)
- FIN7013-chap9-13exam-8th_edition-test
- 7. Capm Beta Apt
- Portfolio Management
- Cost of Capital
- Is CAPM Beta Dead or Alive
- Financial Management MB0045
- Alternatives to CAPM(Damodaran Blog).doc
- AK10(2)
- 408 Final Notes
- International Cost
- Ec Eurozone Forecast Winter 2012
- FINA 4001 Ch 13
- (Risk Management Series) Brian Coyle-Capital Structuring_ Corporate Finance-Global Professional Publishing (2000)
- ch05

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Determining

the Cost of

Capital

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

Copyright 2009 Pearson Prentice Hall. All rights reserved.

12-2

Learning Objectives

Understand the drivers of the firms overall cost of capital.

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

Adjust the cost of capital for the risk associated with the project.

Account for the direct costs of raising external capital.

12-3

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.

12-4

12-5

12-6

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).

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,

(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

Copyright 2009 Pearson Prentice Hall. All rights reserved.

12-8

The market-value balance sheet must still

balance:

Market Value of Equity + Market Value of Debt =

Market Value of Assets

(Eq. 12.1)

12-9

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.

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.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

12-11

(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)

12-12

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?

12-13

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.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

12-14

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

12-15

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.

12-16

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?

12-17

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.

12-18

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

12-19

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.

12-20

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)

12-21

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?

12-22

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

12-23

Execute:

Alcoas effective cost of debt is

0.0609 (1 0.35) = 0.039585 = 3.9585%.

12-24

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%.

12-25

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?

12-26

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)

12-27

Execute:

Gap Inc.s effective cost of debt is

0.0713 (10.40)= .0428 = 4.28%

12-28

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%.

12-29

Firms may also raise capital by issuing preferred stock.

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%.

12-30

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

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)

12-31

12-32

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.

12-33

Equity

Solution:

Plan:

use the CAPM and the CDGM.

1.

2.

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.

12-34

Equity

Solution:

Plan (contd):

Risk-free rate: 4.5%

Equity beta: 1.2

Market risk premium: 5%

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.

12-35

Equity

Execute:

The CAPM says that

Cost of Equity = Risk-Free Rate Equity Beta Market Risk Premium

4.5% + 1.2(5%) = 10.5%

Cost of Equity

$2

Dividend Growth Rate

4% 6.8%

Current Price

$71

12-36

Equity

Evaluate:

the CDGM produces a result of 6.8%.

each method, the two methods do not have to produce the

same answer--in fact, it would be highly unlikely that they

would.

examine the assumptions we made for each approach and

decide which set of assumptions are more realistic.

12-37

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%

grow at a rate of 7.7% per year, the two approaches would

produce the same cost of equity estimate.

12-38

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.

12-39

Equity

Solution:

Plan:

The two ways to estimate HOGs cost of equity are to

use the CAPM and the CDGM.

1.

2.

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.

12-40

Equity

Solution:

Plan (contd):

Risk-free rate: 2.0%

Equity beta: 2.3

Market risk premium: 4.5%

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.

12-41

Equity

Execute:

The CAPM says that

Costof equity Risk freerate EquityBeta MarketRiskPremium

2.0% 2.3 4.5%12.35%

Dividend(inoneyear)

DividendGrowthRate

Current Price

0.40

23.76

Cost of equity

12-42

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.

12-43

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%

at a rate of 10.67% per year, the two approaches would produce

the same cost of equity estimate.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

12-44

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

(Eq. 12.6)

stock, the WACC condenses to:

rwacc = rEE% + rD(1 TC)D%

(Eq. 12.7)

12-45

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%

Copyright 2009 Pearson Prentice Hall. All rights reserved.

12-46

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?

12-47

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.

12-48

Execute:

12-49

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.

12-50

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?

12-51

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.

12-52

Execute:

rwacc = rEE% + rD (1 TC)D%

= (0.108)(0.84) + (0.08)(1 0.40)(0.16)

= .0984 or 9.84%

12-53

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.

12-54

12-55

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

12-56

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.

12-57

12-58

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

12-59

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?

Copyright 2009 Pearson Prentice Hall. All rights reserved.

12-60

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%.

12-61

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)

Copyright 2009 Pearson Prentice Hall. All rights reserved.

12-62

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.

12-63

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?

Copyright 2009 Pearson Prentice Hall. All rights reserved.

12-64

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%.

12-65

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

12-66

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.

12-67

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.

12-68

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.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

12-69

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.

12-70

assuming that the market risk of the project is similar to the

market risk of Alcoa's business.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

12-71

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?

12-72

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.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

12-73

of Business

Execute:

Using the CAPM, we have:

its cost of equity.

12-74

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.

12-75

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?

12-76

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.

12-77

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%

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%

Copyright 2009 Pearson Prentice Hall. All rights reserved.

12-78

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.

12-79

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

12-80

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.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

12-81

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.

12-82

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.

12-83

Execute:

Noting that $800 million is $0.8 billion,:

12-84

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.

12-85

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?

12-86

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

Financing

Execute:

NPV $44.6 1.5

1.8

$2.2 billion

0.071 .03

12-88

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.

12-89

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.

12-90

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?

12-91

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