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7Santikian_FBE 421_sp11_(1)

# 7Santikian_FBE 421_sp11_(1) - FBE 421 Financial A nalysis...

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FBE 421: Financial Analysis & Valuation Lecture 7 Estimating a Firm’s Cost of Capital

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Lecture Outline Value, Cash Flows, and Discount Rates Defining a Firm’s WACC DCF, Firm Value, and the WACC Using DCF to Value an Acquisition Estimating the WACC Evaluate the Firm’s Capital Structure Weights The Cost of Debt The Cost of Preferred Equity Example: Alabama Power Company The Cost of Common Equity Examples: Dell Size Premium Examples: CAKE WACC: Putting It All Together Example: Champion Energy Corporation
Introduction This lecture considers discount rate determination and the cost of capital for the firm as a whole. The firm’s weighted average cost of capital (WACC) is the weighted average of the expected after-tax rates of return of the firm’s various sources of capital. It is the discount rate that should be used to discount the firm’s expected free cash flows to estimate firm value. It can be viewed as its opportunity cost of capital.

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Defining WACC
Defining WACC WACC is defined as the average of the estimated required rates of return for the firm’s interest-bearing debt ( k d ), preferred stock ( k p ), and common equity ( k e ). The weights used for each source of funds are equal to the proportions in which funds are raised. Note that the cost of debt financing is adjusted downward to reflect the interest tax-shield.

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Steps in a WACC Step 1. Estimate capital structure and determine the weights of each component: w d, w p, w e. Step 2. Estimate the opportunity cost of each of the sources of financing: k d, k p, k e , and adjust for the effects of taxes where appropriate. Step 3. Calculate WACC by computing a weighted average of the estimated after-tax costs of capital sources used by the firm.
Estimation Issues Use market weights Use market-based opportunity costs Costs should reflect the current required rates of return, rather than historical rates. Use forward-looking weights and opportunity costs WACC assumes constant capital structure, if this does not exist (i.e. LBO) analyst should apply APV model

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Estimating WACC The connection of the WACC to the discounted cash flow (DCF) estimate of firm value is: Equation 4.2 does not reflect the value of the firm’s non-operating assets, nor does it capture the value of the firm’s excess liquidity  (i.e., marketable securities). We return to the consideration of these points in Chapters 6 and 7.
Illustration – Using DCF to Value an Acquisition An analyst at Morgan Stanley has a client interested in acquiring OfficeMart Inc. Step 1: Forecast FCF Step 2: Estimate Appropriate Discount Rate Assumptions: 40% Debt in Capital Structure with Cost of Debt 5%; Cost of Equity 14%, Tax Rate: 20%, WACC = 10% [i.e., 5%(1 - 20%)0.4 + 14% x 0.6 = 10%].

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7Santikian_FBE 421_sp11_(1) - FBE 421 Financial A nalysis...

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