Slide 1Stock ValuationSources of CapitalWeighted Average Cost of Capital (WACC)WACC FormulaWeightsWeightsRequired ReturnsTax EffectWACC GoalDebt Trade-OffTax Effects and Financial DistressWACC ExampleWACC Example OverviewWACC Example: WeightsWACC Example: Cost of DebtWACC Example: Cost of PreferredWACC Example: Cost of EquityWACC Example: Result1 of 1910:02 AMTopic 15: The Cost of CapitalLarry Schrenk, InstructorFIN 365 Business Finance2 of 1910:02 AMStock Valuation•Sources of Capital•Weighted Average Cost of Capital (WACC)•WACC Example3 of 1910:02 AMSources of Capital•Internal–Retained Earnings•External–Debt–Equity•Pecking Order•Capital as ‘Cost’4 of 1910:02 AM•Interpretation–Average Cost to Firm of Capital•Uses–Firm Cost of Capital–Discounting for Projects•Cautions:–Risk–FinancingWeighted Average Cost of Capital (WACC)5 of 1910:02 AMWACC Formula•Weights (Weighted Average)•Required Returns•Tax Effectwi = weight of assetri = return on assettc = corporate tax rated d c p p s sWACC w r (1– ) w r w rt= + +6 of 1910:02 AMWeightsdpsd p sDebtw = Debt + Preferred + EquityPreferredw = Debt + Preferred + EquityEquityw = Debt + Preferred + EquityNote: w + w + w 1=7 of 1910:02 AM•Two Goals–Forecast–Relate to Project•Decisions–Firm versus Project Weights –Book versus Market–Past versus Future–Actual versus TargetWeights8 of 1910:02 AM•Bonds (rd)–Current YTM on Firm’s Bonds–Return on Firm’s Bond Grade, e.g., AA•Preferred Stock (rp)–Implied Discount Rate from Market•Common Stock (rs)–CAPM–Alternate ModelRequired Returns9 of 1910:02 AM•Key–Dividends: Not Deducible–Interest Payments: Deducible•Effect–Dividends: $1 costs $1–Interest Payments: $1 costs $1(1- tc)•If tc = 30%, $1(1- 0.30) = $0.70•Required Return on Bond–rd(1- tc)Tax Effect10 of 1910:02 AM•Minimize CostWACC GoalCost of CapitalDebt Ratio11 of 1910:02 AM•Why not All Debt Financing?•Trade-Off–Tax Subsidy–Financial DistressDebt Trade-Off12 of 1910:02 AMTax Effects and Financial DistressDebtValue of FirmPresent value of taxshield on debtPresent value offinancial distress costsValue of firm with debt subsidyValue of firm with debt subsidy and financial distressValue of firm with no debt subsidyD*Maximumfirm value13 of 1910:02 AMInvestment AmountsCommon Stock = $50,000 Bonds = $25,000Preferred Shares = $25,000Bond Price = $990Coupon Rate = 8%Period = SemiannualMaturity = 25 YearsPar Value = $1,000WACC ExamplePreferred Share Price = $85Dividend = $8Common StockRisk-Free Rate (rf) = 5%Return on Market (rM) = 12%Beta (b) = 1.1Corporate Tax Rate Corporate Tax Rate (tc) = 35%14 of 1910:02 AM1. Calculate Weights, wd, wp, ws2. Calculate Cost of Equity Capital, rs, using CAPM.3. Calculate Cost of Preferred Capital, rs, using Market Implied Discount Rate4. Calculate Cost of Debt Capital, rd, using YTM.5. Calculate WACC.WACC Example Overview15 of 1910:02 AMWACC Example: WeightsdpsDebt 25w = = Debt + Preferred + Equity 50 25 25Preferred 25w = = Debt + Preferred + Equity 50 25 25Equity 55w = = Debt + Preferred + Equity 50 25 2525%25% 50%=+ +=+ +=+ +16 of 1910:02 AMPrice = $990Coupon Rate = 8%Period = SemiannualMaturity = 25 YearsPar Value = $1,000Yield to Maturity (YTM)P/Y = 2; N = 50; I/Y = 8.09%;PV = -990; PMT = -40; FV = -1,000WACC Example: Cost of Debt17 of 1910:02 AMPrice = $85Dividend = $8Implied Discount RateWACC Example: Cost of Preferredppd d 8.00V = r V 85.009.41%r� = = =18 of 1910:02 AMrf = 5%rM = 12%b = 1.1CAPMWACC Example: Cost of Equity( )( )5 1.112 5 12.70%i f mE r r E r rb= + -�� � ��� � �= + - =19 of 1910:02 AM•wd = 0.25; wp = 0.25; ws = 0.50•rd = 8.09%•rp = 9.41%•rs = 12.70%• tc = 35%WACC Example: Result( ) ( ) ( ) ( )d d c p p s sWACC = w r (1–τ ) + w r + w r= 0.25 0.0809 1 0.35 0.25 0.0941 0.50 0.1270= 0.0131 + 0.0235 + 0.0635 10 0= . 1%- +