Chapter 9 on Valuation and Reporting in Organization

1. Chapter 9: Estimating the Cost
of Capital

2. Table of Content
1.The Cost of Capital
2.The Cost of Equity
3.The Cost of Debt
4.Target Weights
2

3. 1. The Cost of Capital
 In its simplest form, the weighted average cost of capital is the market-
based weighted average of the after-tax cost of debt and cost of equity:
 To determine the weighted average cost of capital, we must calculate its
three components: (1) the cost of equity, (2) the after-tax cost of debt, and
(3) the company’s target capital structure.
3
emd k
V
E
Tk
V
D
 )(1WACC

4. 1.1 Successful Implementation Requires Consistency
Criteria to ensure consistency:
 It must include the opportunity costs of all investors—debt, equity, and so on—
since free cash flow is available to all investors, who expect compensation for the
risks they take.
 It must weight each security’s required return by its target market-based weight,
not by its historical book value.
 Any financing-related benefits or costs, such as interest tax shields, not included
in free cash flow must be incorporated into the cost of capital or valued separately
using adjusted present value.
 It must be computed after corporate taxes (since free cash flow is calculated in
after-tax terms), based on the same expectations of inflation, and match the
duration of the cash flows.
4

5. 1.2 The Cost of Capital: An Example
 The weighted average cost of capital at Home Depot equals 8.5 percent. The majority of enterprise value is held by
equity holders (68.5 percent), whose CAPM-based required return equals 10.4 percent. The remaining capital is
provided by debt holders at 4.2 percent of an after-tax basis.
5
Let’s examine the components of WACC
one by one, starting with the cost of equity…
percent
After-tax Contribution to
Source of Proportion of Cost of Marginal opportunity weighted
capital total capital capital tax rate cost average
Debt 31.5 6.8 37.6 4.2 1.3
Equity 68.5 10.4 10.4 7.1
WACC 100.0 8.5
Home Depot: Weighted Average Cost of Capital

6. 2. The Cost of Equity
 The three most common asset-pricing models differ primarily in how they define
risk.
• The capital asset pricing model (CAPM) states that a stock’s expected
return is driven by how sensitive its returns are to the market portfolio. This
sensitivity is measured using a term known as beta.
• The Fama-French three-factor model defines risk as a stock’s sensitivity to
three portfolios: the stock market, a portfolio based on firm size, and a
portfolio based on book-to-market ratios.
• The arbitrage pricing theory (APT) is a generalized multifactor model, but
unfortunately provides no guidance on the appropriate factors that drive
returns.
 The CAPM is the most common method for estimating expected returns, so we
begin our analysis with that model.
6

7. 2.1 Capital Asset Pricing Model
 A stock’s expected return is driven by three components: the risk-free rate, beta, and the expected market risk
premium.
7
)][(][ fmifi RREBRRE 
Expected
return
of stock i
Expected
market
risk premium
Risk-free
rate
Stock’s
beta
Estimating the Cost of Equity Using the CAPM
Data requirements Considerations
• Risk-free rate Use a long-term government rate dominated
in the same currency as cash flows.
• Market risk premium The market risk premium is difficult to
measure. Various models point to a risk
premium between 4.5 percent and 5.5 percent.
• Company beta To estimate beta, lever the company's
industry beta to the company's target debt-to-
equity ratio.

8. Source: Bloomberg.
0
1
2
3
4
5
0 5 10 15 20
Yieldtomaturity(percent)
Years to maturity
German
Eurobond
zerocoupon bonds
U.S.
Treasury
STRIPS
2.2 Risk-Free Rate: 10-Year Local Treasury
 The cost of capital must be in the same
currency as the company’s financials.
Thus, use a risk-free rate posted by the
local central bank of the company’s
country/region.
 The cost of capital must match the
duration of the cash flows in question. For
long-term project valuation and company
evaluation, use no less than the 10-year
rate.
8
Government Zero Coupon Yields, May 2009

9. 2.3 The Market Risk Premium
 Methods to estimate the market risk premium fall into three general
categories:
1. Estimating the future risk premium by measuring and extrapolating historical
returns.
2. Using regression analysis to link current market variables, such as the
aggregate dividend-to-price ratio, to project the expected market risk
premium.
3. Using DCF valuation, along with estimates of return on investment and
growth, to reverse engineer the market’s cost of capital.
9

10. 2.4 Using Historical Excess Returns: Best
Practices
 To best measure the risk premium using historical data, you should:
1. Calculate the premium over long-term government bonds.
 Use long-term government bonds, because they match the duration of a company’s
cash flows better than do short-term rates.
2. Use the longest period possible.
 If the market risk premium is stable, a longer history will reduce estimation error.
Since no statistically significant trend is observable, we recommend the longest
period possible.
3. Use an arithmetic average of longer-dated intervals (such as five years).
 Although the arithmetic average of annual returns is the best predictor of future
one-year returns, compounded averages will be upward biased (too high).
Therefore, use longer-dated intervals to build discount rates.
4. Adjust the result for econometric issues, such as survivorship bias.
 Predictions based on U.S. data (a successful economy) are probably too high.
10

11. 2.5 When Possible, Use Long-Dated Holding Periods
 To correct for the bias caused by misestimating and/or negative autocorrelation in returns, we have two choices. First, we can calculate
multi-period holding returns directly from the data, rather than compound single-period averages.
 Alternatively, we can use an estimator proposed by Marshall Blume, one that blends the arithmetic and geometric averages.
11
Cumulative Returns for Various Intervals, 1900–2009
percent
U.S. U.S. U.S.
U.S. government excess excess Blume
Arithmetic mean of stocks bonds returns returns estimator
1-year holding periods 11.2 5.4 6.1 6.1 6.1
2-year holding periods 23.7 11.1 12.3 6.0 6.1
4-year holding periods 50.8 23.7 24.4 5.6 6.0
5-year holding periods 66.5 30.7 31.0 5.5 6.0
10-year holding periods 170.7 73.7 69.1 5.4 5.9
Source: Morningstar SBBI data, Morningstar Dimson, Marsh, Staunton Global Returns data.
Annualized returnsAverage cumulative returns

12. 2.6 Embedded Market Risk Premium
Key Value Driver Formula:
12
e
g
Net Income 1-
ROE
Price =
k -g
 
 
 

13. 2.7 Estimating Beta
• According to the CAPM, a stock’s expected return is
driven by beta, which measures how much the stock
and market move together. Since beta cannot be
observed directly, we must estimate its value.
• The most common regression used to estimate a
company’s raw beta is the market model:
• Based on data from 1998 to 2003, Home Depot’s beta
is estimated at 1.37.
13
 mi βRaR
percent
-25
-20
-15
-10
-5
0
5
10
15
20
-20 -15 -10 -5 0 5 10 15 20
HomeDepotmonthlystockreturns
Morgan Stanley Capital Index (MSCI) global monthly returns
Regressionbeta= 1.28
Home Depot: Stock Returns, 2001–2006
Even though Home Depot matched the market in aggregate losses during 2007 and 2008 (37 percent for
Home Depot versus 35 percent for the MSCI World Index), a slight difference in timing caused the two
measures to be uncorrelated. Prior to 2007, Home Depot’s market beta was relatively stable. For this
reason, we measure unlevered beta as of 2006.

14. 2.8 Beta Varies over Time
 Between 1985 and 2008, IBM’s beta
hovered near 0.7 in the 1980s but rose
dramatically in the mid-1990s to a peak
above 1.7 before falling back down. It now
measures near 0.8.
 This rise in beta occurred during a period
of great change for IBM, as the company
moved from hardware (such as
mainframes) to services (such as
consulting).
14
0.0
0.4
0.8
1.2
1.6
2.0
1986 1991 1996 2001 2006
Marketbeta
IBM:Market Beta, 1985-2010
hardware
services

15. 2.9 Estimating Beta: Best Practices
 As can be seen on the previous slide, estimating beta is a noisy process. Based on certain
market characteristics and a variety of empirical tests, we reach several conclusions about
the regression process:
 Raw regressions should use at least 60 data points (e.g., five years of monthly
returns). Rolling betas should be graphed to examine any systematic changes in a
stock’s risk.
 Raw regressions should be based on monthly returns. Using shorter return periods,
such as daily and weekly returns, leads to systematic biases.
 Company stock returns should be regressed against a value-weighted, well-diversified
portfolio, such as the S&P 500 or MSCI World Index.
 Next, recalling that raw regressions provide only estimates of a company’s true beta,
we improve estimates of a company’s beta by deriving an unlevered industry beta and
then relevering the industry beta to the company’s target capital structure.
15

16. 2.10 Operating Risk across Industries
 A company’s beta represents the
company’s exposure to changes in the
overall stock market.
 Since the stock market is closely tied
to the economy, a company’s beta
represents its revenue and cash flow
exposure to the economy’s strength.
16
2.13
1.75
1.55
1.38
1.18
1.12
1.16
1.06
1.00
0.98
0.83
0.63
0.51
Semiconductor Equipment
Life Insurance
Integrated Steel
Specialty Retail
Commodity Chemicals
Information Services
Retail Automotive
Hotel/Gaming
Aggregate Market
Homebuilding
Packaging & Container
Property Management
Water Utility
Unlevered Beta by Sector
Source: Aswath Damodaran,New York University.

17. 2.11 Cost of Equity Using CAPM
 When the beta is high, the stock is
considered more risky than the market.
 For instance, Cisco Systems moves more
than the market, and has a beta of 1.86.
Thus, the company’s cost of equity is 10.4
percent.
 With a beta of 0.73, Raytheon’s cost of
equity is estimated at 7.8 percent.
17
Base Return
Long-Term
Treasuries
4.0%
Below
Average
Risk
Above
Average
Risk
9.2%
14.4%
Raytheon
(7.8%)
Cisco
(10.4%)
Risk-free
rate
Expected
market
return

18. 2.12 An Alternative Model: Fama & French
 In 1992, Eugene Fama and Kenneth French published a paper in the Journal of Finance that
received a great deal of attention because they concluded
 In short, our tests do not support the most basic prediction of the SLB [Sharpe-Lintner-Black]
Capital Asset Pricing Model that average stock returns are positively related to market betas.
 Based on prior research and their own comprehensive regressions, Fama and French concluded
that:
 Equity returns are inversely related to the size of a company (as measured by market
capitalization).
 Equity returns are positively related to the ratio of the book value to market value of the
company’s equity.
 With this model, a stock’s excess returns are regressed on three factors: excess market returns,
the excess returns of small stocks over big stocks (SMB), and the excess returns of high book-to-
market stocks over low book-to-market stocks (HML).
18

19. 2.13 An Alternative Model: Fama & French
 Let’s use the Fama-French three-factor model to continue our Home Depot example. To determine the company’s three betas, Home
Depot stock returns are regressed against the excess market portfolio, SMB, and HML (available from professional service providers).
19
Home Depot: Fama-French Expected Returns
For Home Depot, the
Fama-French model
leads to a slightly
smaller cost of equity
than the market model.
Average Average Contribution
monthly annual to expected
premium 1
premium Regression return
Factor (percent) (percent) coefficient 2
(percent)
Market portfolio 5.4 1.39 7.5
SMB portfolio 0.23 2.8 (0.09) (0.3)
HML portfolio 0.40 5.0 (0.14) (0.7)
Premium over risk-free rate3
6.6
Risk-free rate 3.9
Cost of equity 10.5
1
SMB and HML premiums based on average monthly returns data, 1926–2009.
2
Based on monthly returns data, 2002–2006.
3
Summation rounded to one decimal point.

20. 2.14 An Alternative Model: The Arbitrage Pricing
Theory
 The arbitrage pricing theory (APT) can be thought of as a generalized version of the Fama-French three-factor
model. In the APT, a security’s returns are fully specified by k factors and random noise:
 By creating well-diversified factor portfolios, it can be shown that a security’s expected return must equal the risk-free
rate plus its exposure to each factor times the factor’s excess return (denoted by lambda):
 Implementation of the APT, however, has been elusive, as there is little agreement on either the number of factors,
what the factors represent, or how to measure the factors.
20
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2211 
kkfi bbbrRE λ...λλ][ 2211 

21. 3. Estimating the Cost of Debt
1. Search Bloomberg (or other financial databases) for the yield to
maturity on the company’s long-dated, option-free debt.
 To determine price and yield accurately, use only large trades (> $1 million).
2. If bonds do not trade, instead add a default premium to a benchmark
rate.
 The benchmark rate should be a long-dated local Treasury bond rate.
 The default premium is based on the company’s debt rating.
3. If your company (or client) does not have a debt rating, then use a
scoring model to estimate a rating.
21

22. 3.1 Yield to Maturity of Debt
 When purchasing a bond, investors require compensation. The discount
factor used to value a bond is known as its yield to maturity (YTM).
 A bond’s yield to maturity (YTM) is dependent on two factors:
 Factor #1: the bond’s time to maturity (duration)
 Factor #2: the credit spread for default risk
22
NN
YTM)(1
Face
YTM)(1
1
1
YTM
Coupon
P










23. 3.2 Home Depot: Pricing Example
 To value a bond, use the annuity formula for
coupon payments and present value for the
face value.
 Alternatively, use a spreadsheet to compute the
present value of individual cash flows.
 For U.S. bonds, coupons are paid twice a year.
Therefore, the bond-equivalent yield must be
divided by two for discounting semiannual cash
flows.
23
Home Depot Coupon 5.875
5.875 Bond, maturing 12/16/2036 Yield 5.865
Semiannual Discount Present
Period Date Coupon Yield Factor Value
1 12/16/2010 2.9375 2.9325 1.0293 2.854
2 6/16/2011 2.9375 2.9325 1.0595 2.773
3 12/16/2011 2.9375 2.9325 1.0906 2.694
4 6/16/2012 2.9375 2.9325 1.1226 2.617
5 12/16/2012 2.9375 2.9325 1.1555 2.542
6 6/16/2013 2.9375 2.9325 1.1894 2.470
7 12/16/2013 2.9375 2.9325 1.2242 2.399
8 6/16/2014 2.9375 2.9325 1.2601 2.331
9 12/16/2014 2.9375 2.9325 1.2971 2.265
10 6/16/2015 2.9375 2.9325 1.3351 2.200
… … … … … …
… … … … … …
50 6/16/2035 2.9375 2.9325 4.2425 0.692
51 12/16/2035 2.9375 2.9325 4.3670 0.673
52 6/16/2036 2.9375 2.9325 4.4950 0.654
53 12/16/2036 102.9375 2.9325 4.6268 22.248
Present value: 100.134

24. 3.3 Method 1: Use
Financial Database
24
Home Depot Coupon 5.875
Maturity 12/16/2036
Rating BBB+/Baa1
Trade date Time Price Yield Size
6/18/2010 11:37:19 99.440 5.917 214K
6/18/2010 9:33:40 97.898 6.034 10K
6/18/2010 9:32:39 98.898 5.958 10K
6/17/2010 15:11:00 99.387 5.921 400K
6/17/2010 13:23:11 98.819 5.964 6K
6/17/2010 13:23:11 98.986 5.951 6K
6/17/2010 13:13:20 100.132 5.865 5,000K
6/17/2010 13:06:59 101.539 5.760 10K
6/17/2010 13:06:59 99.414 5.918 10K
6/17/2010 12:31:45 99.745 5.894 4,025K
CUSIP: 437076AS1

25. 3.4 Critical Issue: Liquidity
 Not all long-dated bonds trade on a frequent basis. Consider Procter & Gamble’s 6.45 percent 2026 bond. The bond
traded only a handful of times during a two-month period.
25
Home Depot Coupon 5.875 Procter & Gamble Coupon 6.45
Maturity 12/16/2036 Maturity 1/15/2026
Rating BBB+/Baa1 Rating AA−/Aa3
Trade date Time Price Yield Size Trade date Price Yield Size
6/18/2010 11:37:19 99.440 5.917 214K 6/17/2010 12:32:21 122.615 4.424 4,925K
6/18/2010 9:33:40 97.898 6.034 10K 6/16/2010 12:43:32 117.291 4.853 550K
6/18/2010 9:32:39 98.898 5.958 10K 5/18/2010 9:20:09 114.965 5.054 10K
6/17/2010 15:11:00 99.387 5.921 400K 5/13/2010 13:27:48 113.385 5.190 10K
6/17/2010 13:23:11 98.819 5.964 6K 5/7/2010 9:10:40 117.670 4.829 25K
6/17/2010 13:23:11 98.986 5.951 6K 5/7/2010 9:05:00 119.170 4.706 25K
6/17/2010 13:13:20 100.132 5.865 5,000K 5/7/2010 9:05:00 117.670 4.829 25K
6/17/2010 13:06:59 101.539 5.760 10K 5/6/2010 15:36:04 116.575 4.919 25K
6/17/2010 13:06:59 99.414 5.918 10K 5/5/2010 11:21:49 111.250 5.378 50K
6/17/2010 12:31:45 99.745 5.894 4,025K 5/5/2010 11:21:49 110.875 5.411 50K
CUSIP: 437076AS1 CUSIP: 742718BH1

26. 3.5 Method 2: Add Default Premium to
Benchmark
 A corporate bond’s yield to maturity depends on the benchmark rate
(often government Treasury bonds or LIBOR) plus a default premium.
 How large is the default premium?
 The default premium depends on two statistics:
1. The probability and timing of default
2. The amount recovered by bondholders following default
26
YTM = Benchmark + Default Premium

27. 3.6 Term Structure of Interest Rates
 Often a one-year loan and a 10-year loan will carry different yield to
maturities, even if each loan is default free.
 Long-term interest rates are an average of short-term rates.
http://www.bloomberg.com/markets/rates/index.html
http://stockcharts.com/charts/YieldCurve.html
YTM=Benchmark+DefaultPremium
U.S. Treasury Yield Curve
June 2010
Source: Bloomberg
27

28. 3.7 he Credit Spread for Default Risk
 When a bank (or investor) lends money, it worries that it will
not be paid back. Will the borrower default?
 In order to be compensated for default risk, lenders charge a
premium over the default-free benchmark rate to risky
customers. The higher the chance of default, the higher the
premium will be.
 Rating agencies, such as S&P and Moody’s, rate the default
risk of most bonds (www.standardandpoors.com and
www.moodys.com).
YTM=Benchmark+DefaultPremium
28

29. EXTREMELY STRONG capacity to meet its financial commitments. AAA is the highest issuer credit
rating assigned by Standard & Poor’s.
VERY STRONG capacity to meet its financial commitments. It differs from the highest-rated obligors
only in small degree.
STRONG capacity to meet its financial commitments but somewhat more susceptible to the adverse
effects of changes in circumstances and economic conditions than obligors in higher-rated
categories.
ADEQUATE capacity to meet its financial commitments. However, adverse economic conditions or
changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its
commitments.
------
LESS VULNERABLE in the near term than other lower-rated obligors. However, it faces major
ongoing uncertainties and exposure to adverse business, financial, or economic conditions that
could lead to the obligor’s inadequate capacity to meet its financial commitments.
MORE VULNERABLE to nonpayment than obligations rated BB, but the obligor currently has the
capacity to meet its financial commitments on its obligations. Adverse business, financial, or
economic conditions will likely impair the obligor’s capacity or willingness to meet its financial
commitments.
CURRENTLY VULNERABLE, and is dependent upon favorable business, financial, and economic
conditions to meet its financial commitments.
AAA/Aaa
AA/Aa
A/A
BBB/Baa
BB/Ba
B/B
CCC/Caa
3.8 S&P and Moody’s Ratings
SpeculativeInvestmentGrade
29

30. 3.9 Home Depot: Ratings Example On July 5, 2007, Standard & Poor's ratings service lowered both the corporate credit rating on Home
Depot Inc. to BBB+ from A+ and the CP rating to A-2 from A-1. At the same time, the ratings were
removed from CreditWatch, where they had been placed on June 19, 2007, with negative implications
following the company's announced plans to use $9.5 billion of net proceeds from the sale of HD Supply
and the issuance of $12 billion of senior notes and cash to finance a $22.5 billion share repurchase
program. The CreditWatch resolution follows the company's approval by the U.S. Federal Trade
Commission to sell HD Supply to a consortium of private equity firms. The outlook is stable.
30

31. 3.10 The Credit Spread for Default Risk
• The lower the rating,
the higher the required
yield to maturity.
• Extremely safe bonds
trade at a small
premium to Treasuries.
• “Junk bonds” can
easily yield more than
10 percent. But the
yield is far from
guaranteed!
YTM=Benchmark+DefaultPremium 3.60
4.36
4.44
4.52
4.53
4.55
4.71
4.91
5.24
5.33
6.07
6.99
7.22
7.47
7.93
8.65
8.99
Treasury
AAA
AA+
AA
AA−
A+
A
A−
BBB+
BBB
BBB−
BB+
BB
BB−
B+
B
B−
Yield to Maturity by Debt Rating
10-Year Bonds, Monthly Average
percent, 2009
31

32. 3.11 Default Spreads over Time
 Default spreads change over time. Default spreads rise during times of economic distress. During the financial crisis
of 2008, junk bond spreads spiked from 2 percent to 12 percent.
32
0
2
4
6
8
10
12
Jan-95 Jan-98 Jan-01 Jan-04 Jan-07 Jan-10
Default Spreadby Rating
Treasury
AAA
BBB
BB
0
2
4
6
8
10
12
14
Jan-95 Jan-98 Jan-01 Jan-04 Jan-07 Jan-10
Yield to Maturity by Rating
Treasury
AAA
BBB
BB

33.  Predicting default is key to determining an appropriate credit rating. To this
end, Edward Altman of New York University built a linear model that
combines various financial ratios to build a Z-score.
 X1 = Working Capital/Total Assets
 X2 = Retained Earnings/Total Assets
 X3 = Earnings Before Interest and Taxes/Total Assets
 X4 = Market Value of Equity/Book Value of Total Liabilities
 X5 = Sales/Total Assets
 When the Z-score falls below 1.81, the company has a 90 percent chance of
becoming distressed within a year.
)(0.1)(6.0)(3.3)(4.1)(2.1 54321 XXXXXZ 
3.12 Method 3: Determining the Credit
Rating
33

34. 3.13 Z-Scores and Credit Ratings
 Although rating agencies use a
combination of both financial ratios
and quantitative assessments, the Z-
score can be successfully mapped
back to ratings.
 As Z-scores rise, so do average bond
ratings.
34
6.20
4.73
3.74
2.81
2.38
1.80
0.33
AAA
AA
A
BBB
BB
B
CCC
Average Z-Score by S&P BondRating

35. 3.14 Is the Z-Score Still Relevant?
Default Expert Altman Launches Credit Rating Tool
Default expert Edward Altman is teaming with Risk Metrics Group to offer credit ratings on North American
companies, responding to a need for better default warnings in the wake of a record bankruptcy wave. “We
are excited about it being a significant improvement over existing models that are out there and providing
probability-of-default estimates that are very important to investors," said Altman, a professor of finance at
New York University.
Default probabilities are estimated with a "Z-Metrics" credit analysis tool, a new generation of the widely
known Z-score formula introduced by Altman in 1968 to predict corporate defaults. “It's based on a much
more up-to-date sample, many more new variables, and it includes market value variables as well as
macroeconomic variables that the Z-score didn't," Altman said. "The accuracy level in terms of predicting
defaults and nondefaults is considerably higher than both rating agencies and the old Z-score models," he
said.
—March 2010
35

36. 3.15 Determining the Credit Rating: Other
Ratios
 Market participants are keenly interested in what drives credit rating actions. Although agency models are proprietary,
they have disclosed financial ratios they believe to be important:
36
Financial ratio AAA AA A BBB BB B CCC
EBITDA/revenues (%) 22.2 26.5 19.8 17.0 17.2 16.2 10.5
Return on capital (%) 27.0 28.4 21.8 15.2 12.4 8.7 2.7
EBIT interest coverage (×) 26.2 16.4 11.2 5.8 3.4 1.4 0.4
EBITDA interest coverage (×) 32.0 19.5 13.5 7.8 4.8 2.3 1.1
Funds from operations/total debt (%) 155.5 79.2 54.5 35.5 25.7 11.5 2.5
Free operating cash flow/total debt (%) 129.9 40.6 31.2 16.1 7.1 2.2 −3.6
Debt to EBITDA 0.4 0.9 1.5 2.2 3.1 5.5 8.6
Debt/debt plus equity (%) 12.3 35.2 36.8 44.5 52.5 73.2 98.9
Source: Standard & Poor’s, CreditStats.
Adjusted Key Industrial Financial Ratios, Long-Term Debt
Three-Year (2005−2007) Medians

37. 3.16 Below-Investment-Grade Debt
• Estimate the bond’s price by discounting expected cash flows by the cost
of debt:
• Next, to determine the bond’s yield to maturity, place promised cash
flows, rather than expected cash flows, into the numerator. Then solve
for the yield to maturity:
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38. 4. USING TARGET WEIGHTS TO
DETERMINE THE COST OF CAPITAL
 With our estimates of the cost of equity and after-tax cost of debt, we can now blend the two expected
returns into a single number. To do this, use the target weights of debt and equity to enterprise value, on
a market (not book) basis:
 To estimate the target capital structure for a company you are valuing from an external perspective, use a
combination of three approaches:
 Estimate the company’s current market-value-based capital structure.
 Review the capital structure of comparable companies.
 Review management’s implicit or explicit approach to financing the business and its implications for
the target capital structure.
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39. Questions?
Chapter 8. Forecasting Performance
39