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WACC_handout - The Opportunity Cost of Capital-To maximize...

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The Opportunity Cost of Capital -To maximize the market value of the firm, we need to use the proper required rate of return as the discount rate for NPV analysis -The firm's proper required rate of return can be viewed as its: Opportunity cost of capital (OCC) -What the firm could earn in an alternative investment of similar risk Weighted average cost of capital (WACC) -After-tax cost of new funds available for investment by the firm - For average risk projects, opportunity cost of capital (OCC), the required rate of return, and WACC are the same. - Importance of opportunity cost of capital Gives the minimum acceptable rate of return on new investments with risk levels similar to the risk level of the company. As the opportunity cost of capital increases, the firm’s value falls Discount rate for determining the net present value for projects of average risk Weighted average of the firm's after-tax costs of new financing - The weights used to determine the opportunity cost of capital (or WACC) are the market value weights and not book value weights. Investors are interested in how much capital they currently have at risk; they are not interested in how much they had invested when the securities were issued. Calculating Costs and Financing Proportions: Cost of Debt - Underwriting costs, issuing expenses and sales to the public at a discount reduce the net proceeds that the issuer receives from a debt issue to below the security’s face value. - To calculate the before-tax cost of debt, we solve for the expected yield to maturity ( 29 + - + = 2 value face ue market val g outstandin periods ue market val value face int erest coupon YTM approx -Interest is a tax-deductible expense, therefore the after-tax cost of debt: ( 29 ( 29 n d d n d np R 1 F R R 1 1 1 C B + + + - = firm the cost to tax - Before R bond for the maturity to periods of Number n $1,000) (typically bond the of alue maturity v or Par F period each bond a on paid interest of amount Dollar C tax before - bond the from proceeds Net B d np = = = = = equity common E stock pfd p debt d W R W R T)W - (1 R WACC + + = T) (1 R cos A d - = - debt of t tax fter
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Example 1 : A $1000 par value bond will sell in the market for $1072 and carries a coupon interest rate of 9%. Issuing costs will be 7.5% of the selling price. The number of years to maturity is 15 and the firm’s tax rate is 46%. What is the before-tax and after-tax cost of debt? Example 2: SMU Corporation has debt outstanding with a par value of $1,000 per bond. The face value of all of their debt is $150,000,000 and it is due in 15 years. The coupon rate is 9% compounded semi- annually. The bonds are currently priced to yield 10%. New debt will be issued at par and the flotation costs are 2% of the face value. The corporate income tax rate is 40%. What is the current market value of the outstanding debt? What would be the after-tax cost to the firm of issuing new debt?
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