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.
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Learning Objectives
Understand the drivers of the firms overall cost of capital.
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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,
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(Eq. 12.1)
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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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(Eq. 12.2)
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2.
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2.
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Cost of equity
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(Eq. 12.7)
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6.8807%
6.09%
1
0.35
38,857
38,857
38,857
12.69%
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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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FCF1
$80 million
280
$3,053.33million($3.05billion)
rWACC g
.074 .05
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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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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?
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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.
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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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1.8
$2.2 billion
0.071 .03
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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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