Exam 3: Weighted Average Cost of Capital

Capital Structure

The mix of long-term debt and equity financing.

Includes Stocks and Bonds.

Cost of Capital

The return investors demand if they invested in securities with comparable degrees of risk.

Weighted-Average Cost of Capital (WACC)

The combines costs of all sources of financing using by the firm.

WACC is the rate at which a project’s cash flows are discounted for capital budgeting purposes.

Effect of Taxes

Interest paid on debt is tax deductible.

Therefore, the firm’s cost of debt must be adjusted for this cost savings as follows:

pretax cost of debt X (1 - tax rate)

Market Values

Used to compute the weights (proportions) of the WACC components.

Investor Opportunity Cost

Investors are motivated to invest in an asset based on it expected return, not historic return.

Investors CAN buy assets at historical prices.

Number of Terms

The WACC equation will include a term for each capital component in the capital structure. This is due to each component having its own weight and required rate of return.

Estimating WACC

All we need are weights and costs to find WACC.

3 steps:

1. Find the market value of each security.

2. Find the weight of each security.

3. Find the required rate of return on each security.

Step 1: Finding Market Value of Equity

Market Cap.

The total dollar market value of a company’s outstanding shares of stock (price X quantity).

It’s the price you would pay to buy al; outstanding shares of a firm’s stock.

Step 1: Finding Market Value of Debt

The total dollar market value of a company’s outstanding bonds.

3 presentations of this data:

1. % of par and outstanding face value value.

2. Bond dollar price and outstanding bonds.

3. Outstanding face value and yield to maturity.

Step 2: Finding Weights - Capital Structure Weights (w)

The market value of each capital component expresses as a percentage of the firm’s total market value.

Step 3: Finding Required Rates of Return

Opportunity Cost of Capital.

The minimum return an investor demands for assuming the risk of an asset.

Common Stock, Preferred Stock, and Corporate Bonds.

Required Rate of Return: Common Stock (S3)

Cost of equity is found using CAPM.

CAPM expected return (k).

Requires: Company beta, expected return on the market, and risk-free rate of return.

Required Rate of Return: Preferred Stock (S3)

Dividend Yield.

Return on a perpetuity ( r ).

The cost of preferred stock is found with an algebraic rearranging of the perpetuity formula.

Required Rate of Return: Debt (S3)

Pretax Cost of Debt: the yield to maturity on all outstanding bonds.

Yield to maturity (YTM).