RSM333 lecture3b

# RSM333 lecture3b - The cost of capital Outline I II III IV...

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The cost of capital 3b Outline I. WACC II. Firm’s growth and value creation III. Ex: estimating market values IV. Ex: estimating cost of capital for new stock/debt V. Ex: estimating cost of capital using CAPM

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What is the “cost of capital”? The cost of capital is the minimum return that a company should achieve on its own investments, to earn the cash flow out of which investors can be paid. The cost of capital is also the opportunity cost of funds , since it represents the opportunity cost for investing in assets with the same risk as the firm. We use the weighted average cost of capital (WACC) to measure a firm’s cost of capital. Problems: 1) How do we define the WACC? 2) How do firms use this indicator?
2 Sabrina Buti, Rotman School of Management, RSM 333 WACC formula (1 ) e d S D WACC K K T V V = + - K d = the current required return on debt in the market K e = usually estimated by using CAPM or some other model. The cost of equity times the market value weight of equity The cost of debt after tax times the market value weight of debt

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3 Sabrina Buti, Rotman School of Management, RSM 333 Example: Computing WACC Consider firm DCX whose debt has a market value of \$40 million and with 3 million outstanding shares of stock, each selling for \$20 per share. The firm pays a 15% rate of interest on its new debt and has a beta of 1.41. The corporate tax rate is 34%. Assume that the risk premium on the market is 9.5% and that current Treasury bill rate is 11%. What is the firm WACC?
4 Sabrina Buti, Rotman School of Management, RSM 333 Solution (1) s DCX’s β is 1.41; the (current) risk-free rate is 11%, and the market risk premium is 9.5%. Thus the cost of equity capital is: s The yield on the company’s bond is 15% and the firm is in the 34% marginal tax rate. Thus the cost of debt is: ( ) 11% 1.41 9.5% 24.40% M e F i F k r β r r = + - = + × = (1 ) 15% (1 0.34) 9.9% d C k T × - = × - =

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Sabrina Buti, Rotman School of Management, RSM 333 Solution (2) 5 s DCX’s WACC is given by: s 18.6% is DCX’s cost of capital. It should be used to discount any project where one believes that the project’s risk is equal to the risk of the firm as a whole (1 ) 60 40 24.40% 9.9% 18.6% 100 100 WACC e d C S D k k k T S D S D = × + × × - + + = × + × =
6 Sabrina Buti, Rotman School of Management, RSM 333 When should we use WACC? The weighted average cost of capital (WACC)

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RSM333 lecture3b - The cost of capital Outline I II III IV...

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