4Risk and Cost of Capital6

# 4Risk and Cost of Capital6 - FromRisktotheCostof Capital 1...

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From Risk to the Cost of  Capital 1

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Capital Budgeting Decision Invest in projects that add value to the firm Value projects using cash flows, reflecting the timing and magnitude of cash flows and all side effects Discount cash flows using a discount rate that reflects the risk of the project and cost of capital 2
Going from risk to the cost of capital Last class, we got a better idea of risk, and the tradeoff between risk and return This class, we will discover how this leads to a cost of capital for the firm Also, we will discuss how to adjust this cost of capital to find the cost of capital for specific projects 3

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Cost of Capital theory Ideally, the cost of capital for any project should: Reflect all sources of capital for the firm (equity, debt, preferred stock, etc) Reflect the risk of each capital source Measure returns after taxes Weight returns by the market value of each capital type Change with changes in inflation, changes in capital structure, or changes in systematic risk over time 4
Weighted-Average Cost of Capital  (WACC) Weighted-Average Cost of Capital (WACC) fulfills each of these goals WACC takes into account all sources of financing, their costs, and places the correct relative weights on these costs We will take a look at WACC now, and we will also spend more time on WACC during the financing portion of the course 5

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WACC Example Suppose we have already found the costs of capital and total value of each of our financing sources, and that our tax rate is 40% Total Value (in millions) % of Total Capital Estimated Cost: r Common Stock \$550 55% 14% Debt \$400 40% 7% Pref. Stock \$50 5% 10% Total Capital \$1000 6
WACC Example continued 55% 40% 5% Common Stock Debt Preferred Stock Using current mix of capital types: WACC=(55%)(14%)+(40%)(7%)(1-40%)+(5%)(10%) WACC=9.88% r = 7% (and interest is tax deductible) r = 14% r = 10% 7

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General form of WACC General form: where E, P, and D are the market values of firm equity, preferred stock, and debt, respectively, and V=E+P+D is the total market value of the firm. r denotes cost of capital for each financing source, and T c is the marginal corporate tax rate ) 1 ( WACC c d p e T r V D r V P r V E - + + = 8
Finding the components of cost of capital To find WACC, we need a cost of capital for each of our forms of financing Last class we discussed risk of equity and debt We can use these ideas to estimate costs of capital Brief note: the costs of capital are percentages, not dollar amounts… 9

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First component: Finding the equity  cost of capital,  r e The cost of equity is probably the most difficult to accurately estimate Equity cash flows are uncertain Equity is a subordinated claim to cash We can get estimates of r e in a few ways Historical returns CAPM Fama-French Three-Factor APT Dividend Discount Model 10
What do financial managers actually do? Percentage of CFOs who “always” or “almost always” use a

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4Risk and Cost of Capital6 - FromRisktotheCostof Capital 1...

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