Cost of Capital

Cost of Capital - Required Reading The Cost Capital WACC...

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1 The Cost Capital WACC Finance - I (MGCR 341) – Prof. de Motta Required Reading Chapter 12 , “Determining the Cost of Capital” from Berk, De Marzo , and Harford, Fundamentals of Finance - I (MGCR 341) – Prof. de Motta 2 Corporate Finance. Capital Budgeting and Corporate Finance We now know how to calculate a project’s expected free cash flows ( FCF ) Recall: These are the cash flows available to be paid to all capital suppliers ignoring interest rate tax shields (i.e., as if the project were 100% equity financed) Finance - I (MGCR 341) – Prof. de Motta 3 the project were 100% equity financed). Q. What discount rate should we use for these cash flows? Q. How do we incorporate debt tax shields (if any) into our valuation? A Balance Sheet • A firm’s sources of financing, which usually consist of debt and equity represent its capital Assets Liabilities + Equity Current Assets Debt Long-Term Assets Preferred Equity Equity Finance - I (MGCR 341) – Prof. de Motta 4 equity, represent its capital. • The relative proportions of debt, equity, and other securities that a firm has outstanding constitute its capital structure. • When corporations raise funds from outside investors, they must choose which type of security to issue. The most common choices are financing through equity alone and financing through a combination of debt and equity.
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2 Weighted Average Cost of Capital The weighted average cost of capital ( WACC ) reflects the costs of the different components of financing: E D D T r E D E r r C D E WACC ) 1 ( Finance - I (MGCR 341) – Prof. de Motta 5 Components of the WACC: 1. Cost of equity: r E 2. After tax cost of debt: r D (1 -T C ) 3. Capital Structure Weights: D /( D+E ) Weighted Average Cost of Capital The value of the firm (or, in the case of capital budgeting, the NPV of the project) is: FCF FCF FCF Finance - I (MGCR 341) – Prof. de Motta 6 ... ) 1 ( ) 1 ( 1 3 3 2 2 1 0 WACC WACC WACC r r r V Intuition behind the WACC The cost of capital is a mixture of the returns needed to compensate the creditors and the shareholders for the risk that they are bearing. The cost of capital reflects the following components: Finance - I (MGCR 341) – Prof. de Motta 7 1. The cost of equity: r E 2. The after tax cost of debt: ( 1-T C ) r D WARNING!!! The common intuition for using WACC is: “To be valuable, a project should return more than what it costs us to raise the necessary financing, i.e., our WACC” This intuition is wrong. Finance - I (MGCR 341) – Prof. de Motta 8 Recall: Discount rates are project-specific
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3 Example: “Since Sony has many divisions, it can finance new ventures by issuing debt at a very low rate. Therefore, Sony would have a lower WACC in those new ventures.” Finance - I (MGCR 341) – Prof. de Motta 9 False. The WACC depends on the USE of the resources. It should reflect the risk of these new ventures. The Cost of Capital is Investment Specific
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Cost of Capital - Required Reading The Cost Capital WACC...

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