SML

13-23 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

13-24 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: •RP= C / PV

13-25 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 – TC). RWACC= Equity + Debt Equity × REquity+ Equity + DebtDebt × RDebt ×(1 – TC)RWACC= S+ B S × RS+ S+ B B × RB ×(1 – TC)

13-26 Firm Valuation •The value of the firm is the present value of expected future (distributable) cash flow discounted at the WACC •To find equity value, subtract the value of the debt from the firm value

13-27 Example: International Paper •First, we estimate the cost of equity and the cost of debt. •We estimate an equity beta to estimate the cost of equity. •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.

13-28 Example (continued) •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: RS= RF+ βi × ( RM – RF)= 3% + 0.82×8.4% = 9.89%

13-29 Example (continued) •The yield on the company’s debt is 8%, and the firm has a 37% marginal tax rate. •The debt to value ratio is 32% 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 the project has the same leverage as the firm as a whole. = 0.68 × 9.89% + 0.32 × 8% × (1 – 0.37) = 8.34% RWACC= S+ B S × RS+ S+ B B × RB ×(1 – TC)

13-30 Flotation Costs •Flotation costs represent the expenses incurred upon the issue, or float, of new bonds or stocks. •These are incremental cash flows of the project, which typically reduce the NPV since they increase the initial project cost (i.e., CF0). Amount Raised = Necessary Proceeds / (1-% flotation cost)•The % flotation cost is a weighted average based on the average cost of issuance for each funding source and the firm’s target capital structure: fA= (E/V)* fE+ (D/V)* fD

13-31 Quick Quiz •How do we determine the cost of equity capital? •How can we estimate a firm or project beta? •How does leverage affect beta? •How do we determine the weighted average cost of capital? •How do flotation costs affect the capital budgeting process?

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- Fall '09
- Finance, Corporate Finance, Net Present Value, Weighted average cost of capital, Equity Capital