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1. Pure play. Find several publicly traded
companies exclusively in projects
business.
Use average of their betas as proxy for
projects beta.
Hard to find such companies.
Methods for Estimating Beta for a
Division or a Project
2. Accounting beta. Run regression between
projects ROA and S&P index ROA.
Accounting betas are correlated (0.5
0.6) with market betas.
But normally cant get data on new
projects ROAs before the capital
budgeting decision has been made.
1. When a company issues new
common stock they also have to pay
flotation costs to the underwriter.
2. Issuing new common stock may
send a negative signal to the capital
markets, which may depress stock
price.
Why is the cost of internal equity from
reinvested earnings cheaper than the
cost of issuing new common stock?
Comments about flotation costs:
Flotation costs depend on the risk of the
firm and the type of capital being raised.
The flotation costs are highest for common
equity. However, since most firms issue
equity infrequently, the per-project cost is
fairly small.
We will frequently ignore flotation costs
when calculating the WACC.
Four Mistakes to Avoid
1. When estimating the cost of debt, use
the current interest rate on new debt,
not the coupon rate on existing debt.
2. When estimating the risk premium for
the CAPM approach, dont subtract
the current long-term T-bond rate from
the historical average return on
common stocks.
(More ...)
3. Use the target capital structure to
determine the weights.
If you dont know the target weights,
then use the current market value of
equity, and never the book value of
equity.
If you dont know the market value
of debt, then the book value of debt
often is a reasonable approximation,
especially for short-term debt.
(More...)
4. Capital components are sources of
funding that come from investors.
Accounts payable, accruals, and
deferred taxes are not sources of
funding that come from investors, so
they are not included in the
calculation of the WACC.
We do adjust for these items when
calculating the cash flows of the
project, but not when calculating the
WACC.
WACC Self Test:
If Company has 50% tax rate
% Capital Structure Source Rate Weighted Average
20% Short term Notes @ 10%
30% Long term Bonds @ 5%
10% Preferred Stock @ 10%
40% Common Stock @ 25%
0% Retained Earnings @ 25%
100%
WACC Self Test:
If Company has 50% tax rate
% Capital Structure Source Rate Weighted Average
20% Short term Notes @ 10% 1.0%
30% Long term Bonds @ 5% 0.8%
10% Preferred Stock @ 10% 1.0%
40% Common Stock @ 25% 10.0%
0% Retained Earnings @ 25% 0.0%
100% 12.8%
Use Market Values for WACC:
If Company has
Example: Book Value Market Value % of
Capital
Bonds issued at
Par, trading at 80
$5mm 5% transaction cost =
$4,750,000
$4,000,000 9.0%
Preferred issued
at $100, trading at
60
$1mm 10% transaction cost
= $900,000
$600,000 1.3%
Common issued
at $15, trading at
$40
$15 IPO price x 1mm shares
10% transaction cost =
$13.5mm
$40,000,000 89.7%
Retained Earnings $500,000 0 0%
$44,600,000 100%
Pre-Tax and After-Tax
Relationships
Cash
Flows
Cost of
Capital
Pre-Tax High Pre-Tax High
After Tax Low After Tax Low
What happens if you use Pretax Cash Flow
stream with an After Tax Cost of Capital?
Market Value Relationships
When Stock Market goes DOWN, Cost of Capital goes?
When Stock Market goes UP, Cost of Capital goes?
When Interest Rates go DOWN, Cost of Capital goes?
When Interest Rates go UP, Cost of Capital goes?
When Company Increases DEBT, Cost of Capital goes?
When Company gets riskier, Cost of Capital goes?
UP
DOWN
DOWN
UP
DOWN
UP
What is WACC Used for?
Capital Investments
Mergers & Acquisitions
Which WACC to use?
Expansion of current business with no change in risk?
Enter new business area with different risk profile?
What happens if project does not return at least
the Cost of Capital?
Shareholder Value goes DOWN
Cost of Capital Review
How calculate Kd?
How calculate Ke for Preferred Stock?
How calculate Ke for Common Stock?
How calculate WACC?
When do you use Pretax vs After Tax
WACC?
What does Hurdle Rate refer to?