Chapter 12 - Chapter 12 The Cost of Capital 1 Plan of the...

Info iconThis preview shows pages 1–12. Sign up to view the full content.

View Full Document Right Arrow Icon
1 Chapter 12 The Cost of Capital
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
2 Plan of the lecture Weighted average cost of capital ( WACC ) Example of WACC Interpreting WACC Flotation costs and the cost of capital
Background image of page 2
3 Purpose of Chapter 12 Chapter 10 : how to measure risk ( variance and standard deviation ). Chapter 11 : the expected rate of return on an asset given its risk ( beta ) In these two chapters, we have assumed that firms or projects are financed 100% by equity ( stock ) Chapter 12 is the last step in estimating the opportunity cost of capital What is the cost of capital if a firm is not 100% financed by equity?
Background image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
4 Weighted average cost of capital (WACC) If a firm is financed entirely by equity , its cost of capital is just the return required by investors on the firm’s stocks which is estimated by using e.g. the CAPM However, very few companies are financed 100% by equity. Instead, most firms are financed by a mix of securities (e.g. debt, equity, preferred shares …), each with its own cost of capital ( see the balance sheet on the next slide )
Background image of page 4
5 WACC Assets Liabilities and shareholders' equity Current assets Current liabilities Net fixed assets Long term debt Intangible assets Total equity Total assets = Total liabilities The balance sheet :
Background image of page 5

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
6 WACC A firm’s mix of long term financing ( debt and equity ) is the firm’s capital structure When there is a mix of securities, the company cost of capital is no longer equal to the expected return on the common stocks (equity)
Background image of page 6
7 WACC Instead, the company cost of capital will be the weighted average of the cost of debt plus the cost of equity . The weights are the fractions of the market values ( not book values ) of debt and equity in the firm’s capital structure
Background image of page 7

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
8 WACC Example of the cost of capital : We are told the following about ABC’s capital structure: It has bonds with a market value of $200 million The company also has 10 million common shares outstanding, selling at $30 each This means that the market value of ABC’s equity is $300 million (= $30 × 10 million)
Background image of page 8
9 WACC Example of the cost of capital : The following is ABC’s capital structure ( figures in millions of dollars ): Market value of debt ( D ): $200 (40%) Market value of equity ( E ): $300 (60%) Total value of firm ( V ): $500 (100%)
Background image of page 9

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
10 WACC If we were to purchase a portfolio of all of the securities issued by ABC, the debt as well as the equity, we would own the entire business. So we have the following chain of reasoning value of ABC’s business = value of the portfolio of ABC’s debt and equity risk of ABC’s business = risk of the portfolio expected return on ABC’s business = expected return on the portfolio ABC’s company cost of capital = expected return on the portfolio
Background image of page 10
WACC The expected return on a portfolio is the weighted average of the expected returns on the securities in the portfolio (Chapter 10 ) Therefore, the company cost of capital
Background image of page 11

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 12
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

Page1 / 53

Chapter 12 - Chapter 12 The Cost of Capital 1 Plan of the...

This preview shows document pages 1 - 12. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online