Chapter13_Spring2010

# Chapter13_Spring2010 - Risk Return and Capital Budgeting...

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Risk, Return, and Capital Budgeting Chapter 13

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WACC: Cost of Capital 2 Cost of capital is the opportunity cost or the return that the investors could earn on an alternative investment of similar risk Return on the project must exceed opportunity cost (return required by providers of capital) Opportunity cost of capital is the weighted average of the cost of the last dollar of capital expected to be raised by the firm from each source of financing
3 Capital structure market value of debt: D     pre-tax cost of debt: K d market value of preferred equity: PE  cost of pref. stock : K pe market value of equity: E cost of equity: K e market value of the firm is V= E+D+PE       tax rate: T

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WACC Definition 4 Notation: k d – before-tax cost of new debt k i = k d (1-T) – after-tax cost of new debt T – is the marginal corp. tax rate k pe – cost of preferred shares k e – cost of equity w j = proportion of debt, equity, or preferred stock in the firm’s capital, based on market values e e pe pe d i w k w k w k × + × + × = WACC
Basic Assumptions 5 Efficient markets: we expect prices to reflect all current information available about the firm Current costs are the most relevant. Therefore we need to use market values and NOT book values We can use a firm’s WACC to evaluate a project, as long as the risk of the project is similar to the risk of the firm If project risk is different from firm risk, compute cost of capital for the project separately Cash is negative debt

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e Security Market Value Required Rate of Return Debt \$20 million 8% Preferred stock \$10 million 10% Common equity \$50 million 15% Passive Footwear has a WACC of 12%. Its debt sells at a YTM of 9%, and its tax rate is 40%. Its cost of equity is 15%. If the firm is financed by debt and common equity only, what fraction of the firm is financed by equity? Answer: 68.75% 6 Reactive Industries’ capital structure is shown below. Tax rate is 35%. What is Reactive Industries’ WACC? Answer: 11.93%
Recall that bond price may be determined as We can approximate YTM ( k d ) as: Cost of Debt ( 29 ( 29 ( 29 ( 29 maturity to yield value face payments coupon dollar costs issuance of net price be sometimes will this purposes, our For today. price bond where , 1 1 1 1 1 0 1 0 - - - - + + + - × = + + + = - = d n d d n d n d n t t d k M I P k M k k I k M k I P 7 2 0 0 P M n M - P I YTM annual + +

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Examples 3&4: Cost of Debt 8 Union Gas has an annual bond with 27 years to maturity and a coupon rate of 8.65%. The bond is currently selling for 134.58% of its face value. Union Gas tax rate is 35%. What is Union Gas’ approximate after-tax cost of debt? Answer:
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Chapter13_Spring2010 - Risk Return and Capital Budgeting...

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