capital structure
the mix of long-term debt and equity financing
company cost of capital
defined as the opportunity cost of capital for the firm's existing assets; used to value new assets that have the same risk as the old ones; the company cost of capital is the minimum acceptable rate of return when the firm expands by investing in average
firm value
V = D + E
-value of the existing business.
rate of return to pay interest?
rdebt � D
expected return with additional income
requity � E
company cost of capital =
weighted average of debt and equity returns; must be based on what INVESTORS are actually willing to pay for the company's outstanding securities�that is, based on the securities' market values
rassets =
total income/value of investment
((rdebt � D) + (requity � E))/V
((D/V) x rdebt) + ((E/V) x requity)
weighted average CC =
the expected rate of return investors would demand on a portfolio of all the firm's outstanding securities, adjusted for tax savings due to interest payments
after-tax cost of debt =
(1 - tax rate) � pretax cost
or (1 - Tc) � rdebt
WACC formula =
(D/V � (1 - Tc)rdebt) + (E/V � requity)
debt as a proportion of the total value =
D/V
equity as a proportion of the total value =
E/V
classes of securities
ex. debt and equity
are preferred stock dividends considered tax-deductible expenses?
unlike interest payments, they are not
calculate WACC for a firm with preferred stock as well as common stock and bonds outstanding
(D/V � (1 - Tc)rdebt) + (P/V � rpreferred) + (E/V � requity)
*Tc is corporate tax rate
simple cash-flow worksheet
revenue
- operating expenses
= pretax operating cash flow
- tax rate
= after-tax cash flow
project net present value is calculated by:
discounting the cash flow (which is a perpetuity) at a percentage of weighted-average cost of capital
or
cost (-) + (cash flow/WACC)
rate of return =
after-tax cash flow/cost (can be projected)
if a project has zero NPV when the expected cash flows are discounted at the weighted-average cost of capital, then
the project's cash flows are just sufficient to give debtholders and shareholders the returns they require
market value =
number of shares � share price
CAPM expected return on stock =
risk-free interest rate + (stock's beta � expected market risk premium)
cost of equity =
requity = rf + common stock beta or B(rm ? rf)
CAPM
capital asset pricing model; tells us that investors demand a higher rate of return from stocks with high betas
expected market risk premium
(rm ? rf)
whenever you are given an estimate of the expected return on a common stock,
always look for ways to check whether it is reasonable
constant growth dividend discount model or DDM
estimates the return that investors expect from different common stocks
DDM =
Po = DIV1/(requity - g)
P0 is the current stock price
DIV1 is the forecast dividend at the end of the year
requity is the expected return from the stock
DDM to find requity =
requity = (DIV1/Po) + g
in other words, the expected return on equity is equal to the dividend yield (DIV1/P0) plus the expected perpetual growth rate in dividends (g)
why will the constant-growth formula get you into trouble if you apply it to firms with very high current rates of growth?
because such growth cannot be sustained indefinitely; will lead to an overestimate of the expected return
preferred stock that pays a fixed annual dividend can be valued from the perpetuity formula =
price of preferred = dividend/rpreferred
rpreferred is the appropriate discount rate for the preferred stock
required rate of return on preferred stock formula =
rpreferred = dividend/price of preferred
two costs of debt finance
explicit cost of debt - the rate of interest that bondholders demand
implicit cost - borrowing increases the required return to equity
if the firm increases its debt ratio, both the debt and the equity will become
more risky. the debtholders and equityholders require a higher return to compensate for the increased risk
the weighted-average cost of capital is the return the company needs to earn
after tax in order to satisfy all its security holders
the weighted-average cost of capital is the right discount rate for
average-risk capital investments
free cash flow (FCF)
cash available for distribution to investors after the company has paid for any new capital investment or additions to working capital
rapid growth is good news, not bad, as long as
the business is earning more than the cost of capital on its investments
why do firms compute weighted-average costs of capital?
They need a standard discount rate for average-risk projects. An "average-risk" project is one that has the same risk as the firm's existing assets and operations.
What about projects that are not average?
The weighted-average cost of capital can still be used as a benchmark. The benchmark is adjusted up for unusually risky projects and down for unusually safe ones.
How do firms compute weighted-average costs of capital?
The WACC is the expected rate of return on the portfolio of debt and equity securities issued by the firm. The required rate of return on each security is weighted by its proportion of the firm's total market value (not book value). Since interest payment
How do firms measure capital structure?
Capital structure is the proportion of each source of financing in total market value. The WACC formula is usually written assuming the firm's capital structure includes just two classes of securities, debt and equity. If there is another class, say prefe
How are the costs of debt and equity calculated?
The cost of debt (rdebt) is the market interest rate demanded by bondholders. In other words, it is the rate that the company would pay on new debt issued to finance its investment projects. The cost of preferred (rpreferred) is just the preferred dividen
What happens when capital structure changes?
The rates of return on debt and equity will change. For example, increasing the debt ratio will increase the risk borne by both debt and equity investors and cause them to demand higher returns. However, this does not necessarily mean that the overall WAC
Can WACC be used to value an entire business?
Just think of the business as a very large project. Forecast the business's operating cash flows (after-tax profits plus depreciation), and subtract the future investments in plant and equipment and in net working capital. The resulting free cash flows ca