The firm has decided to lever up to a capital structure of 1 part debt to 1

The firm has decided to lever up to a capital

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¡ 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.
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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
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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:
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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!
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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 )
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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%
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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
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31 The Weighted Average Cost of Capital ¡ The Weighted Average Cost of Capital is given by: Because interest expense is tax-deductible, we multiply the last term by (1 – T C ).
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32 The Weighted Average Cost of Capital (without Preferred Stocks) ¡ The Weighted Average Cost of Capital is given by: Because interest expense is tax-deductible, 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 )
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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.
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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%
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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
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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 )
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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
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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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