CHAPTER 13
Risk, Cost of Capital, and Valuation
WACC
+ The WACC is the appropriate discount rate when calculating the NPV of a
project or firm.
+ We will use WACC to calculate net present value (NPV) of a project
--> NPV > 0 (accept )
--> NPV < 0 (reject)
What is the purpose of the Cost of capital?
• The discount rate for the project should equal the cost of capital for the firm.
• If the firm is all equity, the discount rate is also equal to the firm’s cost of
equity capital. ( nó giống vs tác dụng của WACC nếu công ty là công ty chỉ có
equity)
The IRR is the interest rate that causes the NPV of the project to be zero.
+ If IRR > Cost of capital (accept, because NPV >0)
+ If IRR < Cost of capital (reject, because NPV < 0)
Cost of equity
Cost of equity
Suppose the stock of the Quatram Company, a publisher of college textbooks,
has a beta of 1.6. The firm is 100% equity financed. Quatram is considering a
number of capital budgeting projects that will double its size. Because these
new projects are similar to the firm’s existing ones, the average beta on the
new projects is assumed to be equal to Quatram’s existing beta. The risk-
free rate is 6.5%. What is the appropriate discount rate for these new projects
if the market risk premium is 7.4%?
Cost of equity
Suppose the stock of the Quatram Company, a publisher of college textbooks, has a beta
of 1.6. The firm is 100% equity financed. Quatram is considering a number of capital
budgeting projects that will double its size. Because these new projects are similar to the
firm’s existing ones, the average beta on the new projects is assumed to be equal to
Quatram’s existing beta. The risk-free rate is 6.5%. What is the appropriate discount
rate for these new projects if the market risk premium is 7.4%?
= 0.065 + 1.6 * (0.074)
= 0.1834
The cash flows of the new projects should be discounted at 18.34%.
Cost of equity
Cost of equity
Cost of equity
Cost of equity
The Swanson Corporation’s common stock has a beta of 1.07. If the risk-
free rate is 3.4 percent and the expected return on the market is 11 percent,
what is the company’s cost of equity capital?
Cost of equity
The Swanson Corporation’s common stock has a beta of 1.07. If the risk-
free rate is 3.4 percent and the expected return on the market is 11 percent,
what is the company’s cost of equity capital?
Cost of debt
- Cost of debt: Interest rate required on new debt issuance (i.e., yield to
maturity on outstanding debt).
- For bonds: the current yield to maturity is a good estimate of investor
expected returns and the cost of borrowing.
Cost of debt
Sunrise, Inc., is trying to determine its cost of debt. The firm has a debt issue
outstanding with 23 years to maturity that is quoted at 96 percent of face
value. The issue makes semiannual payments and has an embedded cost of 5
percent annually. What is the company’s pretax cost of debt? If the tax rate is
21 percent, what is the aftertax cost of debt?
Cost of debt
Sunrise, Inc., is trying to determine its cost of debt. The firm has a debt issue outstanding with
23 years to maturity that is quoted at 96 percent of face value. The issue makes semiannual
payments and has an embedded cost of 5 percent annually. What is the company’s pretax cost
of debt? If the tax rate is 21 percent, what is the aftertax cost of debt?
Cost of preferred share
Preferred stock pays a constant dividend in perpetuity.
Cost of preferred share
Ex 1: A share of the preferred stock of Company A, is selling at $10.2 and pays a
dividend of $1.70 per year. Calculate RP
Ex 2: A share of the preferred stock of Company A, is selling at $17.16 and pays a
dividend of $3.5 per year. Calculate RP
Ex 3: A share of the preferred stock of Company A, is selling at $18.16 and pays a
dividend of $1.80 per year. Calculate RP
Cost of preferred share
Ex 1: A share of the preferred stock of Company A, is selling at $10.2 and
pays a dividend of $1.70 per year. Calculate RP
Ex 2: A share of the preferred stock of Company A, is selling at $17.16 and
pays a dividend of $3.5 per year. Calculate RP
Ex 3: A share of the preferred stock of Company A, is selling at $18.16 and
pays a dividend of $1.80 per year. Calculate RP
WACC
The company cost of capital is just a weighted average of the cost of capital
of every instrument a company has issued, it is often referred to as the
weighted average cost of capital (WACC)
WACC
WACC with taxes:
=> In this case, the firm plans to finance the project using a mix of
debt and equity
WACC
If the firm plans to finance the project with only equity, its average cost of
capital would equal its cost of equity.
If the firm plans to finance the project with only debt, its average cost of
capital would be the aftertax cost of debt.
Valuation with WACC
The value of the firm is the present value of expected future cash flow
discounted at the WACC
=> WACC is the appropriate discount rate when calculating the NPV of
a project or firm
We will use WACC to calculate net present value (NPV) of a project
--> NPV > 0: Accept the project
--> NPV < 0: Reject the project
WACC
1. Titan Corporation has 5.4 million shares of common stock outstanding and
125,000 5.8 percent semiannual bonds outstanding, with a par value of
$1,000 each. The common stock currently sells for $53 per share and has a
beta of 1.15; the bonds have 25 years to maturity and sell for 103 percent
of par. The market risk premium is 6.8 percent, T-bills are yielding 2.9
percent, and the company’s tax rate is 22 percent.
a. What is the firm’s market value capital structure?
WACC
a. What is the firm’s market value capital structure?
WACC
1. Titan Corporation has 5.4 million shares of common stock outstanding and
125,000 5.8 percent semiannual bonds outstanding, with a par value of
$1,000 each. The common stock currently sells for $53 per share and has a
beta of 1.15; the bonds have 25 years to maturity and sell for 103 percent
of par. The market risk premium is 6.8 percent, T-bills are yielding 2.9
percent, and the company’s tax rate is 22 percent.
b. If the company is evaluating a new investment project that has the same
risk as the firm’s typical project, what rate should the firm use to discount
the project’s cash flows?
WACC
WACC
2. Given the following information for Huntington Power Co., find the WACC.
Assume the company’s tax rate is 21 percent.
20,000 5.1-percent-coupon bonds outstanding, $2,000 par value, 20
Debt years to maturity, selling for 105 percent of par; the bonds make
semiannual payments.
Common stock 900,000 shares outstanding, selling for $77 per share; the beta is .95.
Market 7 percent market risk premium and 3.5 percent risk-free rate.
2. Given the following information for Huntington Power Co., find the WACC. Assume the company’s tax
rate is 21 percent.
20,000 5.1-percent-coupon bonds outstanding, $2,000 par value, 20 years to maturity, selling for
Debt
105 percent of par; the bonds make semiannual payments.
Common stock 900,000 shares outstanding, selling for $77 per share; the beta is .95.
Market 7 percent market risk premium and 3.5 percent risk-free rate.
WACC
2. Given the following information for Huntington Power Co., find the WACC. Assume the company’s tax
rate is 21 percent.
20,000 5.1 percent coupon bonds outstanding, $2,000 par value, 20 years to maturity, selling for
Debt
105 percent of par; the bonds make semiannual payments.
Common stock 900,000 shares outstanding, selling for $77 per share; the beta is .95.
Market 7 percent market risk premium and 3.5 percent risk-free rate.
WACC
2. Given the following information for Huntington Power Co., find the WACC. Assume the company’s tax
rate is 21 percent.
20,000 5.1 percent coupon bonds outstanding, $2,000 par value, 20 years to maturity, selling for
Debt
105 percent of par; the bonds make semiannual payments.
Common stock 900,000 shares outstanding, selling for $77 per share; the beta is .95.
Market 7 percent market risk premium and 3.5 percent risk-free rate.
WACC
2. Given the following information for Huntington Power Co., find the WACC. Assume the company’s tax
rate is 21 percent.
20,000 5.1 percent coupon bonds outstanding, $2,000 par value, 20 years to maturity, selling for
Debt
105 percent of par; the bonds make semiannual payments.
Common stock 900,000 shares outstanding, selling for $77 per share; the beta is .95.
Market 7 percent market risk premium and 3.5 percent risk-free rate.
WACC
Tutorial
3.
50,000 bonds with a coupon rate of 5.1 percent and a current price quote of
104.5; the bonds have 15 years to maturity and a par value of $1,000. 30,000
Debt
zero coupon bonds with a price quote of 23.6, 30 years until maturity, and a par
value of $10,000. Both bonds have semiannual compounding.
235,000 shares of 3.6 percent preferred stock with a current price of $87 and a
Preferred stock
par value of $100.
2,100,000 shares of common stock; the current price is $79 and the beta of the
Common stock
stock is 1.08.
The corporate tax rate is 23 percent, the market risk premium is 7 percent, and
Market
the risk-free rate is 3.6 percent.
WACC
WACC
