The document discusses the weighted average cost of capital (WACC) and how it is used to value companies. It provides examples of calculating WACC based on a company's capital structure and required rates of return on debt and equity. WACC is the weighted average of the cost of the company's various sources of financing and provides the minimum return needed to attract investors. The document outlines the steps for determining a company's WACC, including calculating market values for debt and equity and determining required rates of return for each.

1. Chapter 12
Fundamentals of
Corporate
Finance
Fifth Edition
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
The Weighted-Average Cost of
Capital and Company
Valuation

2. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
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12- 2
Topics Covered
Geothermal’s Cost of Capital
Weighted Average Cost of Capital (WACC)
Measuring Capital Structure
Calculating Required Rates of Return
Calculating WACC
Interpreting WACC
Valuing Entire Businesses

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12- 3
Cost of Capital
Cost of Capital - The return the firm’s
investors could expect to earn if they
invested in securities with comparable
degrees of risk.
Capital Structure - The firm’s mix of long
term financing and equity financing.

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Cost of Capital
Example
Geothermal Inc. has
the following
structure. Given that
geothermal pays 8%
for debt and 14% for
equity, what is the
Company Cost of
Capital?

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Cost of Capital
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital?
100%
$647
Assets
Value
Market
70%
$453
Equity
Value
Market
30%
$194
Debt
Value
Market

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12- 6
Cost of Capital
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital?
12.2%
=
(.7x14%)
+
(.3x8%)
=
Return
Portfolio

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Cost of Capital
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital? 12.2%
=
(.7x14%)
+
(.3x8%)
=
Return
Portfolio
Interest is tax deductible. Given a 35% tax rate, debt only
costs us 5.2% (i.e. 8 % x .65).
11.4%
=
(.7x14%)
+
(.3x5.2%)
=
WACC

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12- 8
WACC
Weighted Average Cost of Capital (WACC) -
The expected rate of return on a portfolio of
all the firm’s securities.
Company cost of capital = Weighted average of debt
and equity returns.

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12- 9
WACC
V
)
r
x
(E
+
)
r
x
(D
assets
equity
debt
r 
   
equity
V
E
debt
V
D
assets r
x
r
x
r 

s
investment
of
value
income
total
assets =
r

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WACC
Taxes are an important consideration in the
company cost of capital because interest payments
are deducted from income before tax is calculated.

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WACC
Weighted -average cost of capital=
[ ] [ ]
WACC = x (1 - Tc)r + x r
D
V debt
E
V equity

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WACC
Three Steps to Calculating Cost of Capital
1. Calculate the value of each security as a
proportion of the firm’s market value.
2. Determine the required rate of return on
each security.
3. Calculate a weighted average of these
required returns.

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WACC
Example - Executive Fruit has
issued debt, preferred stock and
common stock. The market
value of these securities are
$4mil, $2mil, and $6mil,
respectively. The required
returns are 6%, 12%, and 18%,
respectively.
Q: Determine the WACC for
Executive Fruit, Inc.

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WACC
Example - continued
Step 1
Firm Value = 4 + 2 + 6 = $12 mil
Step 2
Required returns are given
Step 3
[ ] ( ) ( )
WACC = x(1-.35).06 + x.12 + x.18
=.123 or 12.3%
4
12
2
12
6
12

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WACC
Issues in Using WACC
Debt has two costs. 1)return on debt and 2)increased cost of
equity demanded due to the increase in risk
 Betas may change with capital structure
 Corporate taxes complicate the analysis and may change
our decision
[ ] [ ]
B = x B + x B
assets
D
V debt
E
V equity

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Measuring Capital Structure
In estimating WACC, do not use the Book
Value of securities.
In estimating WACC, use the Market Value
of the securities.
Book Values often do not represent the true
market value of a firm’s securities.

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Measuring Capital Structure
Market Value of Bonds - PV of all coupons
and par value discounted at the current
interest rate.

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Measuring Capital Structure
Market Value of Bonds - PV of all coupons
and par value discounted at the current
interest rate.
Market Value of Equity - Market price per
share multiplied by the number of
outstanding shares.

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Measuring Capital Structure
Big Oil Book Value Balance Sheet (mil)
Bank Debt 200
$ 25.0%
LT Bonds 200
$ 25.0%
Common Stock 100
$ 12.5%
Retained Earnings 300
$ 37.5%
Total 800
$ 100%

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Measuring Capital Structure
Big Oil Book Value Balance Sheet (mil)
Bank Debt 200
$ 25.0%
LT Bonds 200
$ 25.0%
Common Stock 100
$ 12.5%
Retained Earnings 300
$ 37.5%
Total 800
$ 100%
If the long term bonds pay an
8% coupon and mature in 12
years, what is their market
value assuming a 9% YTM?
70
.
185
$
09
.
1
216
....
09
.
1
16
09
.
1
16
09
.
1
16
12
3
2






PV

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Measuring Capital Structure
Big Oil MARKET Value Balance Sheet (mil)
Bank Debt (mil) 200.0
$ 12.6%
LT Bonds 185.7
$ 11.7%
Total Debt 385.7
$ 24.3%
Common Stock 1,200.0
$ 75.7%
Total 1,585.7
$ 100.0%

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Required Rates of Return
Bonds
r = YTM
d
r = CAPM
= r + B(r - r )
e
f m f
Common Stock

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Required Rates of Return
Dividend Discount Model Cost of Equity
Perpetuity Growth Model =
solve for re
P =
Div
r - g
0
1
e
r =
Div
P
+ g
e
1
0

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Required Rates of Return
Expected Return on Preferred Stock
Price of Preferred Stock =
solve for preferred
P =
Div
r
0
1
preferred
r =
Div
P
preferred
1
0

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* FCF and PV *
Free Cash Flows (FCF) should be the
theoretical basis for all PV calculations.
FCF is a more accurate measurement of PV
than either Div or EPS.
The market price does not always reflect the
PV of FCF.
When valuing a business for purchase,
always use FCF.

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Capital Budgeting
Valuing a Business
The value of a business or project is usually computed as
the discounted value of FCF out to a valuation horizon
(H).
The valuation horizon is sometimes called the
terminal value and is calculated like PVGO.
H
H
H
H
r
PV
r
FCF
r
FCF
r
FCF
PV
)
1
(
)
1
(
...
)
1
(
)
1
( 2
2
1
1










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Capital Budgeting
Valuing a Business or Project
H
H
H
H
r
PV
r
FCF
r
FCF
r
FCF
PV
)
1
(
)
1
(
...
)
1
(
)
1
( 2
2
1
1









PV (free cash flows) PV (horizon value)

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Capital Budgeting
Example - Concatenator Manufacturing
.
7
.
376
,
2
05
.
085
.
2
.
83
Value)
Horizon 








           
20
.
368
,
1
085
.
1
7
.
376
,
2
085
.
1
5
.
43
085
.
1
7
.
27
085
.
1
9
.
102
085
.
1
1
.
87
085
.
1
72.5
-
PV(FCF) 5
5
4
3
2






