13) FINA 2303 - Spring 2017 - Chapter 13 - 24april17

FINA 2303
Financial Management
Veronique LAFON-VINAIS
Associate Professor of Business Education, Dept of
Finance
Spring 2017
THE COST OF CAPITAL
PART II - CHAPTER 13
2
Chapter Outline
13. 1 A First Look at the Weighted Average Cost of
Capital
13.2 The Firms Costs of Debt and Equity Capital
13.3 A Second Look at the Weighted Average Cost of
Capital
13.4 Using the WACC to Value a Project
13.5 Project-Based Costs of Capital
13.6 When Raising External Capital Is Costly
Copyright 2015 Pearson Education, Inc. All rights reserved.
FINA 2303 Chapter 13 - Outline 3

Learning Objectives
Understand the drivers of the firms overall cost of capital
Measure the costs of debt, preferred stock, and common
stock
Compute a firms overall, or weighted average, cost of
capital
Apply the weighted average cost of capital to value projects
Adjust the cost of capital for the risk associated with the
project
Account for the direct costs of raising external capital
FINA 2303 Chapter 13 Learning Objectives 4

13.1 A First Look at the Weighted Average
Cost of Capital
The Firms Capital Structure
Capital = a firms sources of financing = debt, equity and other
securities outstanding
Capital Structure = the relative proportions of debt, equity and
other securities outstanding
FINA 2303 Chapter 13 First Look at WACC 5

Figure 13.1 A Basic Balance Sheet
In Ch. 2 we have examined the financial statements of firms. We know that the
two sides of the balance sheet must equal each other: Assets = Liabilities +
Equity. Assets is what the firm owns, and liabilities is what it owes, in other
words the liabilities and equities are the sources of financing of the assets.

Figure 13.2 Two Capital Structures

Cost of Capital
Opportunity Cost and the Overall Cost of Capital:
For investors, the choice of investing in a specific firm
represents the opportunity cost of investing in alternative
investments;
therefore the cost of capital of the firm must be equal to or
higher than the investors opportunity cost

Cost of Capital
Weighted Averages and the Overall Cost of Capital
Weighted Average Cost of Capital (WACC) = the average of a
firms equity and debt costs of capital, weighted by the
fractions of the firms value that correspond to debt and equity,
respectively
The weights used in calculating WACC are based on the
Market-Value Balance Sheet:
Market Value of Equity + Market Value of Debt = Market Value
of Assets (Eq. 13.1)
We use market values rather than book value because market
values are forward-looking, based on what the assets are
expected to produce in the future

Cost of Capital
Weighted Average Cost of Capital Calculations
Unlevered Firm = a firm that has no debt outstanding; it
ultimately pays out all the free cash flow generated by its
assets to its shareholders
Levered Firm = a firm that has debt outstanding. Borrowing
money through debt allows equity holders to control highly
valued assets with relatively little investment of their own
money
Leverage = use of debt in the capital structure = relative
amount of debt on a firms balance sheet.

Cost of Capital
The Weighted Average Cost of Capital: Unlevered Firm
rWACC = Equity Cost of Capital
This is because unlevered firms have no leverage, therefore

no cost of debt.

Cost of Capital
The Weighted Average Cost of Capital: Levered Firm
(Eq. 13.2)

Example 13.1 Calculating the Weights in the
WACC
Problem:
Suppose Kenai Corp. has debt with a book (face)
value of $10 million, trading at 95% of face value.
It also has book equity of $10 million, and 1 million
shares of common stock trading at $30 per share.
What weights should Kenai use in calculating its
WACC?

WACC
Solution:
Plan:
Equation 13.2 tells us that the weights are the fractions
of Kenai financed with debt and financed with equity.
Furthermore, these weights should be based on
market values because the cost of capital is based on
investors current assessment of the value of the firm,
not their assessment of accounting-based book values.
As a consequence, we can ignore the book values of
debt and equity.

WACC
Execute:
Ten million dollars in debt trading at 95% of face value
is $9.5 million in market value.
One million shares of stock at $30 per share is $30
million in market value. So, the total market value of
the firm is $39.5 million.
The weights are:
9.5 39.5 = 24.1% for debt and
30 39.5 = 75.9% for equity

WACC
Evaluate:
When calculating its overall cost of capital, Kenai will
use a weighted average of the cost of its debt capital
and the cost of its equity capital, giving a weight of
24.1% to its cost of debt and a weight of 75.9% to its
cost of equity.

Your Turn!
Problem:
Suppose McDonalds Inc. has debt
with a market value of $18 billion
outstanding, and common stock with a
market value of $52 billion, and a
book value of $36 billion.
Which weights should McDonalds use
in calculation of its WACC?

Your Turn (PRS please)
The weights should be:
24.1 and 75.9
25.7 and 74.3
26.1 and 73.9

Solution to Example 13.1a: Calculating the
Weights in the WACC
Plan:
Equation 13.2 tells us that the weights are the fractions
of McDonalds assets financed with debt and financed
with equity.
We know these weights should be based on market
values because the cost of capital is based on
investors current assessment of the value of the firm,
not their assessment of accounting-based book values.
As a consequence, we can ignore the book value of
equity.

Weights in the WACC
Execute:
Given its $18 billion in debt and $52 billion in equity,
the total value of the firm is $70 billion.
18 70 = 25.7% for debt and
52 70 = 74.3% for equity

Weights in the WACC
Evaluate:
When calculating its overall cost of capital, McDonalds
will use a weighted average of the cost of its debt
capital and the cost of its equity capital, giving a weight
of 25.7% to its cost of debt and a weight of 74.3% to its
cost of equity.

13.2 The Firms Costs of Debt and Equity
Capital
Cost of Debt Capital
Yield to Maturity and the Cost of Debt
A firms Cost of Debt is the interest rate it would have to pay to
refinance its existing debt: it is forward looking and based on
current market conditions
The Yield to Maturity (YTM) is the yield that investors demand to
hold the firms debt (new or existing) we learned this in Ch. 6
=> we use YTM as cost of debt
Important!!! The YTM may be different from the coupon rate!
http://finra-
Taxes and the Cost of Debt markets.morningstar.com/BondCenter/Results.jsp
Effective Cost of Debt = firms net cost of interest on its debt after
accounting for the interest tax deduction (assuming there is one!)
rD (1 TC) (Eq. 13.3)
where TC is the corporate tax rate. Copyright 2015 Pearson Education, Inc. All rights reserved.
FINA 2303 Chapter 13 Firms Cost of Debt and Equity 22

Example 13.2 Effective Cost of Debt
Problem:
By using the yield to maturity on DuPonts debt, we
found that its pre-tax cost of debt is 2.81%.
If DuPonts tax rate is 35%, what is its effective cost
of debt?
FINA 2303 Chapter 13 Firms Cost of Debt 23

Solution:
Plan:
We can use Eq. 13.3: rD (1 TC) to calculate DuPonts
effective cost of debt:
rD = 2.81% (pre-tax cost of debt)
TC = 35% (corporate tax rate)

Execute:
DuPonts effective cost of debt is
0.0281 (1 0.35) = 0.01827 = 1.827%.

Evaluate:
For every $1,000 it borrows, DuPont pays its
bondholders 0.0281($1,000) = $28.10 in interest every
year.
Because it can deduct that $28.10 in interest from its
income, every dollar in interest saves DuPont 35 cents
in taxes, so the interest tax deduction reduces the
firms tax payment to the government by 0.35($28.10)
= $9.83.
Thus DuPonts net cost of debt is the $28.10 it pays
minus the $9.83 in reduced tax payments, which is
$18.27 per $1,000 or 1.827%. Copyright 2015 Pearson Education, Inc. All rights reserved.

Your Turn!
Problem:
By using the yield to maturity on Gap Inc.s debt, we
find that its pre-tax cost of debt is 7.13%.
If Gap Inc.s tax rate is 40%, what is its effective cost
of debt?

The effective cost of debt is:
3.57%
4.28%
7.13%

Solution to Example 13.2a: Effective Cost of
Debt
Solution:
Plan:
We can use Eq. 13.3 to calculate GAPs effective cost
of debt:
rD = 7.13%% (pre-tax cost of debt)
TC = 40% (corporate tax rate)

Debt
Execute:
Gap Inc.s effective cost of debt is
0.0713 (10.40)= .0428 = 4.28%

Debt
Evaluate:
For every $1000 it borrows, Gap Inc. pays its
bondholders 0.0713($1000) = $71.30 in interest every
year.
Because it can deduct that $71.30 in interest from its
income, every dollar in interest saves Gap Inc. 40
cents in taxes, so the interest tax deduction reduces
the firms tax payment to the government by
0.40($71.30) = $28.52.
Thus Gap Inc.s net cost of debt is the $71.30 it pays
minus the $28.52 in reduced tax payments, which is
$42.78 per $1,000 or 4.28%. Copyright 2015 Pearson Education, Inc. All rights reserved.

Capital
Cost of Preferred Stock Capital
Holders of preferred stock are generally promised a fixed
dividend, which must be paid before any dividend can be paid
to common stockholders
If the preferred dividend is known and fixed we can estimate
the preferred stocks cost of capital using Eq. 7.7 of Ch7:
rE= Div1/Po + g where g is the growth rate
Prefered Dividend Div pfd (Eq. 3.4)
Cost of Preferred Stock Capital =
Preferred Stock Price Ppfd

Application: Cost of Preferred Stock Capital
Assume DuPonts class A preferred stock has a price
of $66.67 and an annual dividend of $3.50.
Its cost of preferred stock, therefore, is:
Prefered Dividend Div pfd
Cost of Preferred Stock Capital =
Preferred Stock Price Ppfd
$3.50 $66.67 = 5.25%
33
Capital
Cost of Common Stock Capital
We cannot directly observe the cost of common stock, we
must estimate it. We use two models: CAPM and CDGM
Capital Asset Pricing Model (CAPM): Most common approach,
presented in Ch. 12.
Estimate the firms beta of equity, typically by regressing 60
months of the companys returns against 60 months of returns
for a market proxy such as the S&P 500
Determine the risk-free rate, typically by using the yield on
Treasury bills or bonds
Estimate the market risk premium, typically by comparing
historical returns on a market proxy to contemporaneous risk-
free rates

Capital
Apply the CAPM:
Cost of Equity = Risk-Free Rate + Equity Beta Market
Risk Premium

Application: Cost of Common Stock Capital
using CAPM
Assume the equity beta of DuPont is 1.37, the yield on
ten-year Treasury notes is 3%, and you estimate the
market risk premium to be 6%.
Cost of Equity = Risk-Free Rate + Equity Beta Market
Risk Premium
=> DuPonts cost of equity is 3% + 1.37 6% = 11.22%

Capital
Cost of Common Stock Capital using CDGM =
Constant Dividend Growth Model
From Ch. 7
(Eq. 13.5)

Application: Cost of Common Stock Capital
using Constant Dividend Growth Model
Assume in mid-2013, the average forecast for
DuPonts long-run earnings growth rate was 7.9%.
With an expected dividend in one year of $1.80 and
a price of $57.66, the CDGM estimates DuPonts cost
of equity as follows (using Eq. 13.5):
Div1 $1.80
Cost of Equity = g 0.079 0.110 or 11.0%
PE $57.66

Application: DuPonts cost of equity
The two estimates for DuPonts cost of equity are:
12.6% using CAPM
11% using CDGM
They dont match, because they are based on
different assumptions.
The CDGM also assumes a constant long-run growth
rate of dividends, which doesnt hold true for many
companies.
We could use other models we have looked at in
Ch.10-12 to estimate the cost of equity (for example
the DFCF model)
39
Table 13.1 Estimating the Cost of Equity
Generally most
popular approach

Example 13.3 Estimating the Cost of Equity
Problem:
Assume the equity beta for Johnson & Johnson
(ticker: JNJ) is 0.55.
The yield on 10-year treasuries is 3%, and you
estimate the market risk premium to be 6%.
Furthermore, Johnson & Johnson issues dividends at
an annual rate of $2.81.
Its current stock price is $92.00, and you expect
dividends to increase at a constant rate of 4% per year.
Estimate J&Js cost of equity in two ways.
FINA 2303 Chapter 13 Firms Cost of Equity 41

Solution:
Plan:
The two ways to estimate J&Js cost of equity are to
use the CAPM and the CDGM.
The CAPM requires the risk-free rate, an estimate of the
equitys beta, and an estimate of the market risk premium. We
can use the yield on ten-year Treasury bills as the risk-free
rate.
The CDGM requires the current stock price, the expected
dividend next year, and an estimate of the constant future
growth rate for the dividend:

Plan (contd):
Risk-free rate: 3% Current price: $92.00
Equity beta: 0.55 Expected dividend: $2.81
Market risk premium: 6% Estimated future dividend
growth rate: 4%
We can use the CAPM from Chapter 11 to estimate the
cost of equity using the CAPM approach and Eq. 13.5
to estimate it using the CDGM approach.

Execute:
The CAPM says that
Cost of Equity = Risk-Free Rate Equity Beta Market Risk Premium
For J&J, this implies that its cost of equity is:
3% + 0.55 6% = 6.3%
The CDGM says

Dividend (in one year) $2.81
Cost of Equity Dividend Growth Rate 4% 7.1%
Current Price $92.00

Evaluate:
According to the CAPM, the cost of equity capital is
6.3%; the CDGM produces a result of 7.1%.
Because of the different assumptions we make when
using each method, the two methods do not have to
produce the same answerin fact, it would be highly
unlikely that they would.
When the two approaches produce different answers,
we must examine the assumptions we made for each
approach and decide which set of assumptions is more
realistic. Copyright 2015 Pearson Education, Inc. All rights reserved.

Evaluate (contd):
We can also see what assumption about future dividend
growth would be necessary to make the answers
converge
By rearranging the CDGM and using the cost of equity we
estimated from the CAPM, we have:
Dividend (in one year)
Dividend Growth Rate Cost of Equity
Current Price
6.3% 3.1% 3.2%
Thus, if we believe that J&Js dividends will grow at a

rate of 3.2% per year, the two approaches would produce
the same cost of equity estimate.

Your Turn!
Problem:
The equity beta for Harley-Davidson
(HOG) is 2.3.
The yield on 10-year treasuries is
2.0%, and you estimate the market
risk premium to be 4.5%.
Further, HOG issues an annual
dividend of $0.40.
Its current stock price is $23.76, and
you expect dividends to increase at a
constant rate of 6.0% per year.
Estimate HOGs cost of equity in
two ways. Copyright 2015 Pearson Education, Inc. All rights reserved.

The effective cost of equity is:
CAPM:
6.3%
7.05%
12.35%
CDGM:
7.05%
7.68%
12.63%

Example 13.3a Estimating the Cost of Equity
Solution:
Plan:
The two ways to estimate HOGs cost of equity are to
use the CAPM and the CDGM.
The CAPM requires the risk-free rate, an estimate of the
equitys beta, and an estimate of the market risk premium.
We can use the yield on 10-year Treasury bills as the risk-free
rate.
The CDGM requires the current stock price, the expected
dividend next year, and an estimate of the constant future
growth rate for the dividend.

Solution:
Plan (contd):
Risk-free rate: 2.0% Current price: $23.76
Equity beta: 2.3 Expected dividend: $0.40
Market risk premium: 4.5% Estimated future dividend
growth rate: 6.0%
We can use the CAPM from Chapter 12 to estimate the
cost of equity using the CAPM approach and Eq. 13.5
to estimate it using the CDGM approach.

Execute:
The CAPM says that
Cost of Equity=Risk-Free Rate + Equity Beta Market Risk Premium
2.0% 2.3 4.5% 12.35%
The CDGM says that

Cost of Equity= + Dividend Growth Rate
Current Price
0.40
6.0% 1.68% 6.0% 7.68%
23.76

Evaluate:
According to the CAPM, the cost of equity capital is
12.35%; the CDGM produces a result of 7.68%.
Because of the different assumptions we make when
using each method, the two methods do not have to
produce the same answer in fact, it would be highly
unlikely that they would.
When the two approaches produce different answers,
we must examine the assumptions we made for each
approach and decide which set of assumptions is more
realistic. Copyright 2015 Pearson Education, Inc. All rights reserved.

Evaluate (contd):
We can also see what assumption about future dividend
growth would be necessary to make the answers converge.
By rearranging the CDGM and using the cost of equity we
estimated from the CAPM, we have
Dividend Growth Rate = Cost of Equity-
Current Price
12.35% 1.68% 10.67%
Thus, if we believe that Harley-Davidsons dividends will
grow at a rate of 10.67% per year, the two approaches
would produce the same cost of equity estimate.

13.3 A Second Look at the Weighted Average
Cost of Capital
We can now compute the WACC, combining the cost
of debt (rD), cost of preferred stock (rPFD) and cost of
equity (rE) we have calculated before, using the
respective weights of debt (D%), preferred stock (P%)
and equity (E%) and the tax rate (Tc)
WACC Equation (Eq. 13.6)
rwacc = rEE% + rpfd P% + rD(1 TC)D%
For a company that does not have preferred stock, the WACC
condenses to: rwacc = rEE% + rD(1 TC)D% (Eq. 13.7)
FINA 2303 Chapter 13 Second Look at WACC 54

Application: Calculating DuPonts WACC
In mid-2013, the market values of DuPonts common
stock, preferred stock, and debt were $53,240 million,
$221 million, and $14,080 million, respectively.
Its total value was, therefore:
$53,240 million + $221 million + $14,080 million =
$67,541 million.
Given the costs of common stock, preferred stock, and
debt we have already computed, DuPonts WACC in
late mid-2013 was:

Application: Calculating DuPonts WACC
WACC Equation
53, 240 221 14, 080

WACC 12.6% 4.08% 67,541 3.66% 1 0.35 67,541
67,541
10.33%
10.44%

Example 13.4 Computing the WACC
Problem:
The expected return on Targets equity is 11.5%, and
the firm has a yield to maturity on its debt of 6%.
Debt accounts for 18% and equity for 82% of Targets
total market value.
If its tax rate is 35%, what is this firms WACC?

Solution:
Plan:
We can compute the WACC using Eq. 13.7.
To do so, we need to know the costs of equity and
debt, their proportions in Targets capital structure, and
the firms tax rate.
We have all that information, so we are ready to
proceed.

Execute:

Evaluate:
Even though we cannot observe the expected return of
Targets investments directly, we can use the expected
return on its equity and debt and the WACC formula to
estimate it, adjusting for the tax advantage of debt.
Target needs to earn at least a 10.1% return on its
investment in current and new stores to satisfy both its
debt and equity holders.

Your Turn!
Problem:
The expected return on Macys equity is 10.8%, and
the firm has a yield to maturity on its debt of 8%.
Debt accounts for 16% and equity for 84% of Macys
total market value.
If its tax rate is 40%, what is this firms WACC?

The effective cost of equity is:
9.84%
10.13%
11.5%

Solution to Example 13.4a: Computing the
WACC
Plan:
We can compute the WACC using Eq. 13.7.
To do so, we need to know the costs of equity and
debt, their proportions in Macys capital structure, and
the firms tax rate.
We have all that information, so we are ready to
proceed.

WACC
Execute:
rwacc = rEE% + rD(1 TC)D%
= (0.108)(0.84) + (0.08)(1 0.40)(0.16)
= .0984 or 9.84%

WACC
Evaluate:
Even though we cannot observe the expected return of
Macys investments directly, we can use the expected
return on its equity and debt and the WACC formula to
estimate it, adjusting for the tax advantage of debt.
Macys needs to earn at least a 9.84% return on its
investment in current and new stores to satisfy both its
debt and equity holders.

Figure 13.3 WACCs for Real Companies
Cost of equity
computed based
on the companys
equity beta, a risk
free rate of 3% and
a market risk
premium of 6%.
Tax rate 35%. N/A
means there is no
debt.

Cost of Capital
Methods in Practice
Net Debt
When calculating the weights for WACC, it is common
practice to make an adjustment to the debt.
Many practitioners use Net Debt (Net Debt = Debt Cash
and Risk-Free Securities) and measure the market value of
a firms business assets using its Enterprise Value (market
value of equity + net debt) (see Ch2)
(Eq. 13.8)
Market Value of Equity Net Debt
rWACC = rE rD (1 TC )
Enterprise Value Enterprise Value

Cost of Capital
Methods in Practice
The Risk-Free Interest Rate
We should chose a risk free rate corresponding to the investment
horizon of the firms investors
Most firms use the yields on long-term treasury bonds (10 or 30
year T-Bonds)
The Market-Risk Premium
Since 1926, the S&P 500 has produced an average return of
7.7% above the rate for one-year Treasury securities
Since 1962, the S&P 500 has shown an excess return of only
5.5% over the rate for one-year Treasury securities
Most firms use market risk premiums closer to 5% than 7%

Table 13.2 Historical Excess Returns of the
S&P 500 Compared to One-Year Treasury
Bills and Ten-Year U.S. Treasury Securities
One possible explanation for the decline of the risk premium over time may be that more
investors have begun participating in the stock market and the cost of constructing a
diversified portfolio has declined, leading investors to hold less risky portfolios and
demanding less return accordingly.

A projects cost of capital depends on its risk
When the market risk of a project is similar to the average
market risk of the firms investments, its cost of capital is
equivalent to the cost of capital for a portfolio of all the firms
securities.
=>The projects cost of capital is equal to the firms WACC.
WACC incorporates the benefit of interest rate tax
deduction by using the firms after-tax cost of debt
FINA 2303 Chapter 13 Using WACC to Value a Project 70

Levered Value
The value of an investment, including the benefit of the
interest tax deduction, given the firms leverage policy
It is calculated by using the WACC method
WACC Valuation Method
Discounting future incremental free cash flows using the firms
WACC, which produces the levered value of a project
(Eq. 13.9)

Example 13.5 The WACC Method
Problem:
Suppose Anheuser-Busch InBev is considering
introducing a new ultra-light beer with zero calories to
be called BudZero.
The firm believes that the beers flavor and appeal to
calorie-conscious drinkers will make it a success.
The cost of bringing the beer to market is $200
million, but Anheuser-Busch InBev expects first year
incremental free cash flows from BudZero to be $100
million and to grow at 3% per year thereafter.
If Anheuser-Busch InBevs WACC is 5.7%, should it go
ahead with the project? Copyright 2015 Pearson Education, Inc. All rights reserved.

Solution:
Plan:
We can use the WACC method shown in Eq. 13.9 to
value BudZero and then subtract the up-front cost of
$200 million.
We will need Anheuser-Busch InBevs WACC, which is
5.7%.

Execute:
The cash flows for BudZero are a growing perpetuity.
Applying the growing perpetuity formula with the
WACC method, we have:

Evaluate:
The BudZero project has a positive NPV because it is
expected to generate a return on the $200 million far in
excess of Anheuser-Busch InBevs WACC of 5.7%.
As discussed in Chapter 8, taking positive-NPV
projects adds value to the firm.
Here, we can see that the value is created by
exceeding the required return of the firms investors.

Your Turn!
Problem:
Suppose Starbucks is considering introducing a new Caff
Mocha with zero calories to be called Caff Mucho. The firm
believes that the coffees flavor and appeal to calorie-
conscious coffee drinkers will make it a success.
The risk of the project is judged to be similar to the risk of
the company. Starbucks WACC is estimated in Fig. 13.3 as
11.0%.
The cost of bringing the Caff Mucho to market is $280
million, but Starbucks expects first-year incremental free
cash flows from Caff Mucho to be $80 million and to grow
at 5% per year thereafter.
Should Starbucks go ahead with the project?

Yes
No

Example 13.5a The WACC Method
Solution:
Plan:
We can use the WACC method shown in Eq. 13.9 to
value Caff Mucho and then subtract the upfront cost
of $280 million.
Starbucks WACC was estimated in Figure 13.3 as
11.0%.

Execute:
The cash flows for Caff Mucho are a growing
perpetuity.
Applying the growing perpetuity formula with the
WACC method, we have:
FCF1 $80million
V0L FCF0 280 $1,053.33million ($1.05billion)
rWACC g 0.11 .05

Evaluate:
The Caf Mucho project has a positive NPV because
it is expected to generate a return on the $280 million
far in excess of Starbucks WACC of 11.0%.
As discussed in Chapter 3, taking positive-NPV
projects adds value to the firm.
Here, we can see that the value is created by
exceeding the required return of the firms investors.

Key Assumptions
Average Risk
We assume initially that the market risk of the project is
equivalent to the average market risk of the firms investments
In that case, we assess the projects cost of capital based on the
risk of the firm
Constant Debt-Equity Ratio
We assume that the firm adjusts its leverage continuously to
maintain a constant ratio of the market value of debt to the
market value of equity (the debt-to-equity ratio)
This policy determines the amount of debt the firm will take on
when it accepts a new project.
It implies that the risk for the firms equity and debt, and therefore
its WACC, will not fluctuate owing to leverage changes

Key Assumptions (contd)
Limited Leverage Effects
We assume initially that the main effect of leverage on valuation
follows from the interest tax deduction and that any other factors
are not significant at the level of debt chosen

Key Assumptions (contd)
Assumptions in Practice
These assumptions are reasonable for many projects and firms
The first assumption is likely to fit typical projects of firms with
investments concentrated in a single industry
The second assumption reflects the fact that firms tend to
increase their levels of debt as they grow larger
The third assumption is especially relevant for firms without very
high levels of debt where the interest tax deduction is likely to be
the most important factor affecting the capital budgeting decision

Application: Extending the Life of a DuPont
Facility
Suppose DuPont is considering an investment that
would extend the life of one of its chemical facilities for
four years
The project would require upfront costs of $6.67
million plus a $24 million investment in equipment
The equipment will be obsolete in four years and will
be depreciated via straight-line over that period

WACC Method Application: Extending the
Life of a DuPont Facility
During the next four years, however, DuPont expects
annual sales of $60 million per year from this facility
Material costs and operating expenses are expected to
total $25 million and $9 million, respectively, per year
DuPont expects no net working capital requirements
for the project, and it pays a tax rate of 35%.

Table 13.3 Expected Free Cash Flow from
DuPonts Facility Project

WACC Method Application: Extending the
Life of a DuPont Facility
19 19 19 19
V0L 2
3
4
$59.80 million
1.1033 1.1033 1.1033 1.1033
NPV = $59.80 million - $28.34 million = $31.46

million

Summary of WACC Method
1. Determine the incremental free cash flow of the
investment
2. Compute the weighted average cost of capital using Eq.
13.6
3. Compute the value of the investment, including the tax
benefit of leverage, by discounting the incremental free cash
flow of the investment using the WACC

13.5 Project-Based Costs of Capital
So far we assumed that both the risk and the leverage of
the project under consideration matched those
characteristics for the firm as a whole
This assumption allowed us in turn to assume that the cost
of capital for a project matched the firms cost of capital
In reality, specific projects often differ from the average
investment made by the firm
For example, GE operates many different lines of business. Projects
in the health care division are likely to have different risks than those
in the air transportation division.
Projects may also vary in terms of the amount of leverage
they will support

Application: Cost of Capital of a New
Acquisition
Suppose DuPont is considering entering the athletic
shoe business and acquiring Nike
Nike faces different market risks than DuPont does in
its chemicals business
What cost of capital should DuPont use to value a
possible acquisition of Nike?
FINA 2303 Chapter 13 Project-Based Cost of Capital 90

Application: Cost of Capital of a New
Acquisition
Because the risks are different, DuPonts WACC would
be inappropriate for valuing Nike
Instead, DuPont should calculate and use Nikes
WACC of 7.9% when assessing the acquisition
We find Nikes WACC in Fig 13.3, based on a tax rate
of 35%
This assumes DuPont will find it appropriate to

continue to finance Nike with the same mix of debt and
equity after it buys it.

Application: Divisional Costs of Capital
Now assume DuPont decides to create an athletic shoe
products division internally, rather than buying Nike
What should the cost of capital for the new division be?
If DuPont plans to finance the division with the same
proportion of debt as is used by Nike, then DuPont would
use Nikes WACC as the WACC for its new division
Because Nikes WACC is the right cost of capital given the risks of
athletic shoes and 2% debt financing, it should be the right cost of
capital for an internally created athletic shoes division that is
financed 2% with debt
In most cases, firms with more than one division would not
use a single company-wide WACC to evaluate projects;
rather, they benchmark their own divisions off competitors in
the same line of business Copyright 2015 Pearson Education, Inc. All rights reserved.

Example 13.6 A Project in a New Line of
Business
Problem:
You are working for Microsoft evaluating the possibility of
selling digital video recorders (DVRs).
Microsofts WACC is 8.8%.
DVRs would be a new line of business for Microsoft,
however, so the systematic risk of this business would likely
differ from the systematic risk of Microsofts current
business.
As a result, the assets of this new business should have a
different cost of capital.
You need to find the cost of capital for the DVR
business. Assuming that the risk-free rate is 3% and the
market risk premium is 6%, how would you estimate the
cost of capital for this type of investment?

Business
Solution:
Plan:
The first step is to identify a company operating in
Microsofts targeted line of business.
TiVo, Inc., is a well-known marketer of DVRs. In fact,
that is all TiVo does.
Thus, the cost of capital for TiVo would be a good
estimate of the cost of capital for Microsofts proposed
DVR business.
Many Web sites are available that provide betas for
traded stocks, including http://finance.yahoo.com .

Business
Solution:
Plan (contd):
Suppose you visit that site and find that the beta of
TiVo stock is 1.45.
With this beta, the risk-free rate, and the market risk
premium, you can use the CAPM to estimate the cost
of equity for TiVo.
Fortunately for us, TiVo has no debt, so its cost of
equity is the same as its cost of capital for its assets.

Business
Execute:
Using the CAPM, we have:
Because TiVo has no debt, its WACC is equivalent to

its cost of equity.

Business
Evaluate:
The correct cost of capital for evaluating a DVR
investment opportunity is 11.7%.
If we had used the 8.6% cost of capital that is
associated with Microsofts existing business, we would
have mistakenly used too low a cost of capital.
That could lead us to go ahead with the investment,
even if it truly had a negative NPV.

Your Turn!
Problem:
You are working for H.J. Heinz Company evaluating the
possibility of selling a beverage.
Heinz WACC is 6.6%. Beverages would be a new line of
business for Heinz, however, so the systematic risk of this
business would likely differ from the systematic risk of
Heinz current business. As a result, the assets of this new
business should have a different cost of capital.
You need to find the cost of capital for the beverage
business. Assuming that the risk-free rate is 3.0% and the
market risk premium is 5.4%, how would you estimate the
cost of capital for this type of investment?

Solution to Example 13.6a: A Project in a
New Line of Business
Plan:
The first step is to identify a company operating in
Heinz targeted line of business.
Coca-Cola Company is a well-known marketer of
beverages. In fact, that is almost all Coca-Cola does.
Thus the cost of capital for Coca-Cola would be a good
estimate of the cost of capital for Heinz proposed
beverage business.
Many Web sites are available that provide company
betas, including http://finance.yahoo.com .

Solution to Example 13.6a A Project in a New
Line of Business
Plan (contd):
Suppose you visit that site and find that the beta of
Coca-Cola is 0.4.
With this beta, the risk-free rate, and the market risk
premium, you can use the CAPM to estimate the cost
of equity for Coca-Cola.
Coca-Cola has a market value debt/assets ratio of
0.58, and its cost of debt is 3.8%. Its tax rate is 28%.
We can now calculate the WACC for Coca-Cola

The correct WACC to use is:
3.8%
5.2%
6.6%

Line of Business
Execute:
Using the CAPM, we have:
Coca Cola 'scost of equity = Risk-free rate + Coca - Cola 's betaMarket Risk Premium
3% .4 5.4% 5.8%
5.2%
To get Coca-Colas WACC, we use equation 13.6.

Coca-Cola has no preferred stock, so the WACC is:
rWACC rE E% rD (1 TC )D%
55.2%
.8%(0.42) 3.8%(1 .28)(0.58) 4.3.8%
02%

Line of Business
Evaluate:
The correct cost of capital for evaluating a beverage
investment opportunity is 3.8%.
If we had used the 6.6% cost of capital that is
associated with Heinz existing business, we would
have mistakenly used too high of a cost of capital.
That could lead us to reject the investment, even if it
truly had a positive NPV.

13.6 When Raising External Capital Is Costly
Issuing new equity or bonds carries a number of costs
Issuing costs (such as cost of filing or registering with the SEC
and bankers fees) should be treated as cash outflows that are
necessary to the project
They can be incorporated as additional costs (negative cash
flows) in the NPV analysis
Generally, a project that can be financed internally will be less
costly overall than the same project financed with external
funds
FINA 2303 Chapter 13 Costly Capital 104

Example 13.7 Costly External Financing
Problem:
You are analyzing DuPonts potential acquisition of Nike.
DuPont plans to offer $65 billion as the purchase price for
Nike, and it will need to issue additional debt and equity to
finance such a large acquisition.
You estimate that the issuance costs will be $800 million
and will be paid as soon as the transaction closes.
You estimate the incremental free cash flows from the
acquisition will be $3.3 billion in the first year and will grow
What is the NPV of the proposed acquisition?

Solution:
Plan:
We know from Section 13.5 that the correct cost of
capital for this acquisition is Nikes WACC (7.9%). We
can value the incremental free cash flows as a growing
perpetuity:

Solution:
Plan: (contd)
The NPV of the transaction, including the costly
external financing, is the present value of this growing
perpetuity net of both the purchase cost and the
transaction costs of using external financing.

Execute:
Noting that $800 million is $0.8 billion,:

Evaluate:
It is not necessary to try to adjust Nikes WACC for the
issuance costs of debt and equity.
Instead, we can subtract the issuance costs from the
NPV of the acquisition to confirm that the acquisition
remains a positive-NPV project even if it must be
financed externally.

Your Turn!
Problem:
You are analyzing Microsofts potential acquisition of Yahoo!
in February of 2008. Microsoft plans to offer $44.6 billion
as the purchase price for Yahoo!, and it will need to issue
additional debt and equity to finance such a large
acquisition.
Yahoos WACC is 7.1%.
You estimate that the issuance costs will be $1.5 billion
and will be paid as soon as the transaction closes.
You estimate the incremental free cash flows from the
acquisition will be $1.8 billion in the first year and will grow
What is the NPV of the proposed acquisition?

the NPV of the proposed
acquisition is:
1.5Bn
-1.5Bn
2.2Bn
-2.2Bn

Solution to Example 13.7a: Costly External
Financing
Plan:
We know from Section 13.5 that the correct cost of
capital for this acquisition is Yahoo!s WACC (7.1%).
We can value the incremental free cash flows as a
growing perpetuity: PV CF (r g) 1
where
CF1 $1.8 billion
r Yahoo!' s WACC 7.1%
g 3%

Financing
Plan: (contd)
The NPV of the transaction, including the costly
external financing, is the present value of this growing
perpetuity net of both the purchase cost and the
transaction costs of using external financing.

Financing
Execute:
1.8
NPV $44.6 1.5 $2.2 billion
0.071 .03

Financing
Evaluate:
It is not necessary to try to adjust Yahoo!s WACC for
the issuance costs of debt and equity.
Instead, we can subtract the issuance costs from the
NPV of the acquisition to see that the acquisition is a
negative-NPV project.
Microsoft should NOT have acquired Yahoo!

Chapter Quiz
1. Why do we use market value weights in the weighted
average cost of capital?
2. What are the major tradeoffs in using the CAPM versus
the CDGM to estimate the cost of equity?
3. Why do different companies have different WACCs?
4. What inputs do you need to be ready to apply the WACC
method?
5. What types of additional costs does a firm incur when
accessing external capital?
FINA 2303 Chapter 13 Chapter Quiz 116

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FINA 2303

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FINA 2303 Chapter 13 - Outline 3

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FINA 2303 Chapter 13 Learning Objectives 4

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FINA 2303 Chapter 13 First Look at WACC 5

FINA 2303 Chapter 13 First Look at WACC 6

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FINA 2303 Chapter 13 First Look at WACC 7

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FINA 2303 Chapter 13 First Look at WACC 8

FINA 2303 Chapter 13 First Look at WACC 9

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FINA 2303 Chapter 13 First Look at WACC 10

This is because unlevered firms have no leverage, therefore

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FINA 2303 Chapter 13 First Look at WACC 11

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FINA 2303 Chapter 13 First Look at WACC 21

FINA 2303 Chapter 13 Firms Cost of Debt and Equity 22

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FINA 2303 Chapter 13 Firms Cost of Debt 23

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$3.50 $66.67 = 5.25%

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