Lecture 13: WACC, floatation costs, leverage & beta, industry beta

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16 Terms

1
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What is the cost of capital formula? (The Wacc)

The weighted average cost of capital

  • ws = weight of equity

  • wd = weight of debt

  • rs = cost of equity

  • rd = cost of debt

  • Tc = corporate tax rate

  • interest expense is tax deductible so multiply by (1 - T) to find after tax cost of debt

<p>The weighted average cost of capital</p><ul><li><p>ws = weight of equity</p></li><li><p>wd = weight of debt</p></li><li><p>rs = cost of equity</p></li><li><p>rd = cost of debt</p></li><li><p>Tc = corporate tax rate</p></li></ul><ul><li><p>interest expense is tax deductible so multiply by (1 - T) to find after tax cost of debt</p></li></ul><p></p>
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What is the WACC (cost of capital) with preferred shares formula?

wp = weight of preferred shares

rp = cost of preferred share

<p>wp = weight of preferred shares</p><p>rp = cost of preferred share</p>
3
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What is the WACC (weighted average cost of capital) from investors & firm’s perspective?

Investors: tells us the returns of investing in a firm

Firms: tells us the average cost of issuing debt

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What is the WACC used for?

WACC is the discount rate used in capital budgeted & used to discount free-cash-flow to find firm’s value

  • used to make investing decisions between projects

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What are the 4 steps to estimating the WACC?

  1. estimate cost of equity

  2. estimate cost of debt

  3. estimate weights of equity & debt

  4. compute cost of capital

<ol><li><p>estimate cost of equity</p></li><li><p>estimate cost of debt</p></li><li><p>estimate weights of equity &amp; debt</p></li><li><p>compute cost of capital</p></li></ol><p></p>
6
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  1. What are the 3 methods to estimating cost of equity?

  1. CAPM

  2. Dividend valuation (less common)

  3. Bond yield plus risk premium (least common)

<ol><li><p>CAPM</p></li><li><p>Dividend valuation (less common)</p></li><li><p>Bond yield plus risk premium (least common)</p></li></ol><p></p>
7
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What risk free rate do you use in the CAPM equation?

It depends on what the WACC is used for

  • in asset pricing (investments), always use the T-bill rate as the risk-free rate!

8
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  1. How do you estimate the cost of debt?

Use the YTM (yield to maturity) that the firm uses to pay their debts!

  • if firm has outstanding bonds, the weighted average of YTM on these bonds can be used as market’s required rate of return on new debt

  • if no outstanding bonds, bonds of similar companies/same industry can be used

<p>Use the YTM (yield to maturity) that the firm uses to pay their debts!</p><ul><li><p>if firm has outstanding bonds, the weighted average of YTM on these bonds can be used as market’s required rate of return on new debt</p></li><li><p>if no outstanding bonds, bonds of similar companies/same industry can be used</p></li></ul><p></p>
9
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Do you include short term debt in WACC calculations?

Usually not → WACC is used for capital budgeting (long-term asset decisions)

  • focus on long-term debt

  • Exclude: if short term debt is used to finance current operations

  • Include: if short term debt is used to finance a long-term asset (bad idea because uncertainty about new interest rates when more short-term debts are needed)

10
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  1. How do you estimate the weights of equity & debt?

Multiply the market price by the shares outstanding

  • take the sum and multiply by the total to find the weights

<p>Multiply the market price by the shares outstanding</p><ul><li><p>take the sum and multiply by the total to find the weights</p></li></ul><p></p>
11
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  1. How do you estimate the cost of capital?

Use the WACC formula!

<p>Use the WACC formula!</p>
12
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What are floatation costs?

Costs of issuing new securities → measured as a percentage of security price

  • to account for floatation costs, use P x (1 - F)

<p>Costs of issuing new securities → measured as a percentage of security price</p><ul><li><p>to account for floatation costs, use P x (1 - F) </p></li></ul><p></p>
13
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How much will Beta change relative to changes in leverage?

More leverage = more risk → Beta measures risk and will obviously increase, but by how much?

Assets = Debt + Equity

<p>More leverage = more risk → Beta measures risk and will obviously increase, but by how much?</p><p>Assets = Debt + Equity </p>
14
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What is an asset beta and equity beta?

  • Asset beta (unlevered beta) - beta of a firm with no debt → no leverage

  • Equity beta (levered beta) - beta of a firm with debt → leverage

15
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What are some specific issues with project WACC?

A project’s cost of capital depends on risk of the project not the risk of the firm

  • if risk of new project is different from existing operations, should apply a different discount rate

<p>A project’s cost of capital depends on risk of the project <strong>not </strong>the risk of the firm</p><ul><li><p>if risk of new project is different from existing operations, should apply a different discount rate</p></li></ul><p></p>
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How do you use industry/comparable betas?

  1. Find comparable companies with similar operations to estimate the WACC

  2. Estimate the industry Beta

  3. Un-lever the beta by finding beta without debt

  4. Re-lever to reflect company structure & taxes

<ol><li><p>Find comparable companies with similar operations to estimate the WACC</p></li><li><p>Estimate the industry Beta</p></li><li><p>Un-lever the beta by finding beta without debt</p></li><li><p>Re-lever to reflect company structure &amp; taxes</p></li></ol><p></p>