¡
The firm has decided to lever up to a
capital structure of 1 part debt to 1 part
equity.
¡
Assuming that its asset beta remains 0.90.
25
Example
¡
Assuming a zero beta for its debt, its
equity beta would become twice as large:
b
Asset
= 0.90 =
1 + 1
1
×
b
Equity
b
Equity
=
2
×
0.90 = 1.80
26
Example
¡
Rapid is currently all equity and has
a beta of 0.8. The firm desires to
have 1 part of debt and 2 parts of
equity.
¡
Assuming that the asset beta
remains the same and debt beta of
0, we have:
27
Example
¡
If 1 part of debt to 1 part of equity, equity
beta will be:
2
.
1
,
2
1
1
8
.
0
),
1
(
=
÷
ø
ö
ç
è
æ
+
´
=
+
=
Equity
Equity
Asset
Equity
S
B
b
b
b
b
6
.
1
1
1
1
8
.
0
=
÷
ø
ö
ç
è
æ
+
´
=
Equity
b
Financial leverage always increases the equity beta!
28
Cost of Debt
¡
Interest rate required on new debt
issuance (i.e., yield to maturity on
outstanding debt)
¡
Adjust for the tax deductibility of
interest expense
¡
Cost of debt (after corporate tax) =
R
B
x (1
–
t
C
)
29
Example
¡
Borrowing Rate (
R
B
)= 10%
¡
Tax Rate (
t
C
) = 40%
¡
After tax cost of debt =
R
B
x (1
–
t
C
) =
10% x (1
–
0.4) = 6%
30
Cost of Preferred Stock
¡
Preferred stock is a perpetuity,
so its price is equal to the
coupon
paid
divided
by
the
current required return.
¡
Rearranging,
the
cost
of
preferred stock is:
l
R
P
= C / PV
31
The Weighted Average Cost of Capital
¡
The Weighted Average Cost of Capital is given
by:
•
Because interest expense is taxdeductible, we
multiply the last term by (1 –
T
C
).
32
The Weighted Average Cost of Capital
(without Preferred Stocks)
¡
The Weighted Average Cost of Capital is given
by:
•
Because interest expense is taxdeductible, we
multiply the last term by (1 –
T
C
).
R
WACC
=
Equity + Debt
Equity
×
R
Equity
+
Equity + Debt
Debt
×
R
Debt
×
(1 –
T
C
)
R
WACC
=
S
+
B
S
×
R
S
+
S
+
B
B
×
R
B
×
(1 –
T
C
)
R
WACC
= W
S
×
R
S
+
W
B
×
R
B
×
(1 –
T
C
)
33
Steps to Compute WACC
¡
First, we estimate the cost of equity
and the cost of debt.
l
We estimate an equity beta to
estimate the cost of equity.
l
We can often estimate the cost of
debt by observing the YTM of the
firm
’
s debt.
¡
Second, we determine the WACC by
weighting
these
two
costs
appropriately.
34
Example: International Paper
¡
The industry average beta is 0.82,
the risk free rate is 3%, and the
market risk premium is 8.4%. Thus,
the cost of equity capital is:
R
S
=
R
F
+
b
i
×
(
R
M
–
R
F
)
= 3% + 0.82
×
8.4%
= 9.89%
35
Example: International Paper
¡
The yield on the company
’
s debt is
8%, and the firm has a 37%
marginal tax rate.
¡
Thus, the cost of debt is:
¡
The company has no preferred stock.
)
37
.
0
1
(
%
8
)
1
(
R
B

´
=

´
C
T
36
Example: International Paper
¡
The debt to value ratio is 32%
¡
Thus, the WACC is:
= 0.68
×
9.89% + 0.32
×
8%
×
(1 – 0.37)
= 8.34%
R
WACC
=
S
+
B
S
×
R
S
+
S
+
B
B
×
R
B
×
(1 –
T
C
)
37
Example: International Paper
o
8.34% is International’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 and
38
Capital Budgeting & Project Risk
¡
A firm that uses one discount rate
(
e.g. WACC
) for all projects may over
time increase the risk of the firm
while decreasing its value.
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 Fall '15