Exam 3 and Chapter 13 Notes

Exam 3 and Chapter 13

• For exam number three, the content from chapter 16 will be conceptual.

• A review for exam three will be given in class.

Weighted Average Cost of Capital (WACC)

• Chapter 13 combines concepts from earlier chapters.

• In previous chapters, components of WACC were presented without full context.

• An example of cash inflows discounted to the present value was seen in chapter 7.

  • If the present value of cash inflows > cost, accept the project (positive PV).

  • If the present value of cash inflows < cost, reject the project (negative PV).

• A mini cash flow statement helps determine the numerators for present value projects.

• Chapter 13 integrates concepts from:

  • Chapter 7

  • Stock chapter

  • Chapter 11 (computing required return)

Equations Review

• Weighted Average Cost of Capital (WACC) Formula:
  WACC = wd * rd + we * re
  where:

  • w_d = weight of debt

  • r_d = cost of debt

  • w_e = weight of equity

  • r_e = cost of equity

• Capital Asset Pricing Model (CAPM) or Security Market Line (SML) Equation:
  Required Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate)

  • Market risk premium is the slope, calculated as (Market Return - Risk-Free Rate).

  • Risk-free rate is the y-intercept.

  • Asset's risk premium = Market risk premium * Firm's beta coefficient.

  • If beta = 1, asset's risk premium = market risk premium.

Capital Structure

• Capital structure is a financing decision (Chapter 1).

• Balance sheet uses book values (historical cost).

• Market values are what should be considered for current valuation.

Example: Big Oil

• Balance Sheet (Book Values):

  • Long-term bonds outstanding: 200,000,000

  • Stock outstanding: 100,000,000

• Total Capital Structure (Book Value): 800,000,000

• Initial Weights (based on book value)

  • Weight of Debt: 50% (400,000,000 / 800,000,000)

  • Weight of Equity: 50% (400,000,000 / 800,000,000)

Market Value Calculation:

• Market Value of Bonds:

  • Present value of all future cash flows (coupon payments + return of principal) discounted at the yield to maturity.

  • If bonds pay an 8% coupon, but the required return is 9%, they sell at a discount.

  • Example: Market value of bonds is 385,700,000.

• Market Value of Common Stock:

  • Current selling price per share * number of shares outstanding.

  • Example: 12/share * 100,000,000 shares = 1,200,000,000

Comparing Book Value vs. Market Value

• Book Value Weights:

  • Debt: 200,000,000 / 800,000,000

  • Equity: 100,000,000 / 800,000,000

• Market Value Weights:

  • Debt: 385,700,000 / (385,700,000 + 1,200,000,000) = 24.3%

  • Equity: 1,200,000,000 / (385,700,000 + 1,200,000,000) = 75.7%

Cost of Equity (Using CAPM)

• Required Return = Risk-Free Rate + Beta * Market Risk Premium

  • Risk-Free Rate = 8%

  • Beta = 0.57

  • Market Risk Premium = 7%

• Required Return = 0.08 + 0.57 * 0.07 = 11.99

WACC as Discount Rate

• WACC is the appropriate discount rate for a project if it's a carbon copy of the firm.
  Companies in multiple lines of business should use the WACC of comparable single-business companies.

Externalities of Debt

• Issuing more debt increases firm risk.

• Stockholders require a higher return as a result.

• Implicit Cost: Stockholders require a higher return because the firm has become riskier due to increased debt.

• Explicit Cost: Firm gets downgraded, leading to higher interest rates on debt.

Valuing a Business

• Compute the total value of the corporation

• Divide by the number of shares outstanding to determine the price per share

• Free Cash Flow: cash available to investors (bondholders and stockholders).

• Present Value of an Uneven Cash Flow Stream (Chapter 5).

• Value of the corporation is the present value of all future free cash flows discounted back to the present at the firm's weighted average cost of capital (WACC).

Terminal Value

• Terminal Value: value of the firm when it reaches a steady state (constant growth rate).

• Steady state growth rate: the growth rate the firm expects to grow at after the supernormal growth phase ends.

Example

• A firm can borrow at 5% (cost of debt).

• WACC is 8.78%.

Free Cash Flow (FCF) Statement

• Start with sales.

  • Isolate sales from whatever division of the company you're analyzing.

• Subtract costs.

• EBITDA

• Subtract Deprecation

• Profit before taxes.

• Subtract Taxes

• Profit after tax.

• Add back depreciation to arrive at operating cash flow.

Free Cash Flow Forecasting

• Free cash flow in year one: 7,100,000.

• The book will typically provide statements for years 1-6.

• Base case scenario can vary.

H Horizon Value

• Horizon Year: Year number five.

• Year six FCF (396,300,000) represents the present value of all cash flows after year six to infinity.

• The horizon value considers FCF starting in year six and extending beyond.

• To find value of firm, take the free cash flow in year one and then discount that back one year via (1 + WACC). Add the present value of the horizon value.

• Compute the horizon value:

Horizon Value = \frac{Free Cash Flow_{Year 6}}{WACC - Growth Rate}