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Chapter 13 The Cost of Capital • Financial manager must determine their firm’s overall cost of capital based all sources of financing. This overall cost of capital is a critical input into the capital budgeting process. •The valuation principle tell us that the value of a project is the present value of its benefits net of the present value of its costs. In capital budgeting, we implement this important concept with net present value (NPV). To calculate a project’s NPV, we need a cost of capital to use a discount rate. NPV = PV (Benefits) – PV (Costs) Chapter 13 13. 1 A First Look at the Weighted Average Cost of Capital 13.2 The Firm’s 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 Learning Objectives Understand the drivers of the firm’s overall cost of capital Measure the costs of debt, preferred stock, and common stock Compute a firm’s overall, or weighted average, cost of capital Learning Objectives (cont’d) 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 13.1 A First Look at the Weighted Average Cost of Capital The Firm’s Capital Structure Capital: A firm’s sources of financing, which usually consist of debt and equity, represent its capital. Capital Structure: The relative proportions of debt, equity and other securities that a firm has outstanding constitute its capital structure. Figure 13.1 A Basic Balance Sheet Figure 13.2 Two Capital Structures 13.1 A First Look at the Weighted Average Cost of Capital Opportunity Cost and the Overall Cost of Capital Financial mangers take into account each component of the firm’s capital structure when determining the firm’s overall cost of capital . Throughout the discussion that follows, keep in mind the intuition behind the term “ cost of capital”. When investors buy the stock or bonds of a company, they forgo the opportunity to invest that money elsewhere. The expected return from those alternative investments constitutes an opportunity cost to them. Thus, attract their investments as capital to the firm, the firm must offer potential investors an expected return equal to what they could expect to earn elsewhere for assuming the same level of risk. 13.1 A First Look at the Weighted Average Cost of Capital Weighted Averages and the Overall Cost of Capital Weighted Average Cost of Capital (WACC) Market-Value Balance Sheet Market Value of Equity + Market Value of Debt = Market Value of Assets (Eq. 13.1) 13.1 A First Look at the Weighted Average Cost of Capital Weighted Average Cost of Capital Calculations Leverage Unlevered: firms that pays out all of the free cash flows generated by its assets to its equity holders. Levered: Firm’s financing comes from debt. Borrowing money through debt allows equity holders to control highly valued assets with relatively little investment of their own money. We refer to the relative amount of debt on the balance sheet a s the firm’s leverage. 13.1 A First Look at the Weighted Average Cost of Capital Weighted Average Cost of Capital Calculations The Weighted Average Cost of Capital: Unlevered Firm If a firm is unleveraged, so that it has no debt, all of the free cash flows generated by its assets are ultimately paid out to its equity holders. Because the free cash flows to the equity holders are the same as the free cash flows from the assets, the valuation Principle tells us that the market value , risk , and cost of capital for the firm’s equity are equal to the corresponding amounts for its assets. Given this relationship, we cam eliminate the firm’s equity cost of capital using the CAPM. rWACC = Equity Cost of Capital 13.1 A First Look at the Weighted Average Cost of Capital Weighted Average Cost of Capital Calculations The Weighted Average Cost of Capital: Levered Firm By holding a portfolio of the firm’s equity and debt, we can get the same cash flows as if we held the assets directly. The return of a portfolio is equal to the weighted average of the returns of the securities in it. This equality implies the following relationship: (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? Example 13.1 Calculating the Weights in the 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. Example 13.1 Calculating the Weights in the 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 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 Example 13.1 Calculating the Weights in the 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. 13.2 The Firm’s Costs of Debt and Equity Capital Cost of Debt Capital Yield to Maturity and the Cost of Debt The Yield to Maturity is the yield that investors demand to hold the firm’s debt (new or existing). Taxes and the Cost of Debt Effective Cost of Debt rD (1 TC) where TC is the corporate tax rate. (Eq. 13.3) Example 13.2 Effective Cost of Debt Problem: By using the yield to maturity on DuPont’s debt, we found that its pre-tax cost of debt is 3.66%. If DuPont’s tax rate is 35%, what is its effective cost of debt? Example 13.2 Effective Cost of Debt Solution: Plan: We can use Eq. 13.3 to calculate DuPont’s effective cost of debt: rD = 6.09% (pre-tax cost of debt) TC = 35% (corporate tax rate Example 13.2 Effective Cost of Debt Execute: DuPont’s effective cost of debt is 0.0366 (1 0.35) = 0.02379 = 2.379%. Example 13.2 Effective Cost of Debt Evaluate: For every $1000 it borrows, DuPont pays its bondholders 0.0366($1000) = $36.60 in interest every year. Because it can deduct that $36.60 in interest from its income, every dollar in interest saves DuPont 35 cents in taxes, so the interest tax deduction reduces the firm’s tax payment to the government by 0.35($36.60) = $12.81. Thus DuPont’s net cost of debt is the $36.60 it pays minus the $12.81 in reduced tax payments, which is $23.79 per $1000 or 2.379%. 13.2 The Firm’s Costs of Debt and Equity Capital Cost of Preferred Stock Capital Div pfd Prefered Dividend Cost of Preferred Stock Capital = Preferred Stock Price Ppfd (Eq. 13.4) Assume DuPont’s class A preferred stock has a price of $66.67 and an annual dividend of $3.50. Its cost of preferred stock, therefore, is $3.50 ÷ $66.67 = 5.25% 13.2 The Firm’s Costs of Debt and Equity Capital Cost of Common Stock Capital Capital Asset Pricing Model From Chapter 12 1. Estimate the firm’s beta of equity, typically by regressing 60 months of the company’s returns against 60 months of returns for a market proxy such as the S&P 500. 2. Determine the risk-free rate, typically by using the yield on Treasury bills or bonds. 13.2 The Firm’s Costs of Debt and Equity Capital Cost of Common Stock Capital Capital Asset Pricing Model From Chapter 12 3. Estimate the market risk premium, typically by comparing historical returns on a market proxy to contemporaneous risk-free rates. 4. Apply the CAPM: Cost of Equity = Risk-Free Rate + Equity Beta × Market Risk Premium 13.2 The Firm’s Costs of Debt and Equity Capital Cost of Common Stock Capital Capital Asset Pricing Model 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%. DuPont’s cost of equity is 3% + 1.37 × 6% = 11.22% 13.2 The Firm’s Costs of Debt and Equity Capital Cost of Common Stock Capital Constant Dividend Growth Model (Eq. 13.5) 13.2 The Firm’s Costs of Debt and Equity Capital Cost of Common Stock Capital Constant Dividend Growth Model Assume in mid-2010, the average forecast for DuPont’s long-run earnings growth rate was 6.2%. With an expected dividend in one year of $1.64 and a price of $36.99, the CDGM estimates DuPont’s cost of equity as follows (using Eq. 13.5): Cost of Equity = Div1 $1.64 g 0.062 0.106 or 10.6% PE $36.99 Table 13.1 Estimating the Cost of Equity Example 13.3 Estimating the Cost of Equity Problem: The equity beta for Johnson & Johnson (ticker: JNJ) is 0.67. The yield on ten-year treasuries is 3%, and you estimate the market risk premium to be 6%. Further, Johnson & Johnson issues dividends at an annual rate of $2.16. Its current stock price is $60.50, and you expect dividends to increase at a constant rate of 4% per year. Estimate J&J’s cost of equity in two ways. Example 13.3 Estimating the Cost of Equity Solution: Plan: The two ways to estimate J&J’s cost of equity are to use the CAPM and the CDGM. 1. 2. The CAPM requires the risk-free rate, an estimate of the equity’s 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: Example 13.3 Estimating the Cost of Equity Solution: Plan (cont’d): Risk-free rate: 3% Current price: $60.50 Equity beta: 0.67 Expected dividend: $2.16 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. Example 13.3 Estimating the Cost of Equity 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% + 0.67 × 6% = 7.0% The CDGM says Cost of Equity Dividend (in one year) $2.16 Dividend Growth Rate 4% 7.6% Current Price $60.50 Example 13.3 Estimating the Cost of Equity Evaluate: According to the CAPM, the cost of equity capital is 7.0%; the CDGM produces a result of 7.6%. 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. 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: Example 13.3 Estimating the Cost of Equity Evaluate (cont’d): Dividend Growth Rate Cost of Equity Dividend (in one year) Current Price 7% 3.6% 3.4% Thus, if we believe that J&J’s dividends will grow at a rate of 3.4% per year, the two approaches would produce the same cost of equity estimate. Example 13.3a Estimating the Cost of Equity 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 HOG’s cost of equity in two ways. Example 13.3a Estimating the Cost of Equity Solution: Plan: The two ways to estimate HOG’s cost of equity are to use the CAPM and the CDGM. 1. The CAPM requires the risk-free rate, an estimate of the equity’s beta, and an estimate of the market risk premium. We can use the yield on 10-year Treasury bills as the risk-free rate. 2. The CDGM requires the current stock price, the expected dividend next year, and an estimate of the constant future growth rate for the dividend. Example 13.3a Estimating the Cost of Equity Solution: Plan (cont’d): 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. Copyright © 2009 Pearson Prentice Hall. All rights reserved. 13-38 Example 13.3a Estimating the Cost of Equity Execute: The CAPM says that Cost of Equity=Risk-FreeRate + EquityBeta × Market Risk Premium 2.0% 2.3 4.5% 12.35% The CDGM says that Dividend (in one year) + Dividend Growth Rate Current Price 0.40 6.0% 1.68% 6.0% 7.68% 23.76 Cost of Equity= Example 13.3a Estimating the Cost of Equity 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. Example 13.3a Estimating the Cost of Equity Evaluate: 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- Dividend (in one year) Current Price 12.35% 1.68% will 10.67% Thus, if we believe that Harley-Davidson’s dividends 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 WACC Equation rwacc = rEE% + rpfd P% + rD(1 TC)D% (Eq. 13.6) For a company that does not have preferred stock, the WACC condenses to: rwacc = rEE% + rD(1 TC)D% (Eq. 13.7) 13.3 A Second Look at the Weighted Average Cost of Capital WACC Equation In mid-2010, the market values of DuPont’s common stock, preferred stock, and debt were $30,860 million, $187 million, and $9543 million, respectively. Its total value was, therefore, $30,860 million + $187 million + $9543 million = $40,590. Given the costs of common stock, preferred stock, and debt we have already computed, DuPont’s WACC in late 2010 was: 13.3 A Second Look at the Weighted Average Cost of Capital WACC Equation 30,860 187 9,543 WACC 11.22% 5.25% 1 0.35 3.66% 40,590 40,590 40,590 9.11% Example 13.4 Computing the WACC Problem: The expected return on Target’s 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 Target’s total market value. If its tax rate is 35%, what is this firm’s WACC? Example 13.4 Computing the 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 Target’s capital structure, and the firm’s tax rate. We have all that information, so we are ready to proceed. Example 13.4 Computing the WACC Execute: Example 13.4 Computing the WACC Evaluate: Even though we cannot observe the expected return of Target’s 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. Example 13.4a Computing the WACC Problem: The expected return on Macy’s 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 Macy’s total market value. If its tax rate is 40%, what is this firm’s WACC? Example 13.4a Computing the 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 Macy’s capital structure, and the firm’s tax rate. We have all that information, so we are ready to proceed. Example 13.4a Computing the WACC Execute: rwacc = rEE% + rD (1 TC)D% = (0.108)(0.84) + (0.08)(1 0.40)(0.16) = .0984 or 9.84% Example 13.4a Computing the WACC Evaluate: Even though we cannot observe the expected return of Macy’s 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. Macy’s 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. Example 13.4b Computing the WACC Problem: The expected return on Honeywell International’s (HON) equity is 12.0%, and the firm has a yield to maturity on its debt of 5.1%. Debt accounts for 28% and equity for 72% of HON’s total market value. If its tax rate is 39%, what is this firm’s WACC? Example 13.4b Computing the 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 HON’s capital structure, and the firm’s tax rate. We have all that information, so we are ready to proceed. Example 13.4b Computing the WACC Execute: rwacc = rEE% + rD (1 TC)D% = (0.120)(0.72) + (0.051)(1 0.39)(0.28) = .0951 or 9.51% Example 13.4b Computing the WACC Evaluate: Even though we cannot observe the expected return of Honeywell’s 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. Honeywell needs to earn at least a 9.51% return on its investment in current and new stores to satisfy both its debt and equity holders. Figure 13.3 WACCs for Real Companies 13.3 A Second Look at the Weighted Average Cost of Capital Methods in Practice Net Debt Net Debt = Debt – Cash and Risk-Free Securities (Eq. 13.8) rWACC Market Value of Equity Net Debt = rE rD (1 TC ) Enterprise Value Enterprise Value 13.3 A Second Look at the Weighted Average Cost of Capital Methods in Practice The Risk-Free Interest Rate Most firms use the yields on long-term treasury bonds The Market-Risk Premium Since 1926, the S&P 500 has produced an average return of 7.1% above the rate for one-year Treasury securities Since 1959, the S&P 500 has shown an excess return of only 4.7% over the rate for one-year Treasury securities Table 13.2 Historical Excess Returns of the S&P 500 Compared to One-Year Treasury Bills and Ten-Year U.S. Treasury Securities 13.4 Using the WACC to Value a Project Levered Value The value of an investment, including the benefit of the interest tax deduction, given the firm’s leverage policy WACC Valuation Method Discounting future incremental free cash flows using the firm’s WACC, which produces the levered value of a project 13.4 Using the WACC to Value a Project Levered Value FCF3 FCF1 FCF2 V ... 2 3 1 rWACC 1 rWACC 1 rWACC L 0 (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 beer’s flavor and appeal to calorie-conscious drinkers will make it a success. The risk of the project is judged to be similar to the risk of the company. 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 InBev’s WACC is 5.7%, should it go ahead with the project? Example 13.5 The WACC Method Solution: Plan: We can use the WACC method shown in Eq. 13.9 to value BudZero and then subtract the upfront cost of $200 million. We will need Anheuser Busch InBev’s WACC, which is 5.7%. Example 13.5 The WACC Method Execute: The cash flows for BudZero are a growing perpetuity. Applying the growing perpetuity formula with the WACC method, we have: Example 13.5 The WACC Method 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 InBev’s WACC of 5.7%. 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 firm’s investors. Example 13.5a The WACC Method Problem: Suppose Starbucks is considering introducing a new Caffè Mocha with zero calories to be called Caffè Mucho. The firm believes that the coffee’s 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. The cost of bringing the Caffè Mucho to market is $280 million, but Starbucks expects first-year incremental free cash flows from Caffè Mucho to be $80 million and to grow at 5% per year thereafter. Should Starbucks go ahead with the project? Example 13.5a The WACC Method Solution: Plan: We can use the WACC method shown in Eq. 13.9 to value Caffè Mucho and then subtract the upfront cost of $280 million. We will need Starbucks’ WACC, which was estimated in Figure 13.3 as 11.0%. Example 13.5a The WACC Method Execute: The cash flows for Caffè Mucho are a growing perpetuity. Applying the growing perpetuity formula with the WACC method, we have: V0L FCF0 FCF1 $80million 280 $1,053.33million ($1.05billion) rWACC g 0.11 .05 Example 13.5a The WACC Method Evaluate: The Café 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 firm’s investors. 13.4 Using the WACC to Value a Project Key Assumptions Average Risk We assume initially that the market risk of the project is equivalent to the average market risk of the firm’s investments 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 13.4 Using the WACC to Value a Project Key Assumptions (cont’d) 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 13.4 Using the WACC to Value a Project WACC Method 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 13.4 Using the WACC to Value a Project 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 DuPont’s Facility Project 13.4 Using the WACC to Value a Project WACC Method Application: Extending the Life of a DuPont Facility V0L 19 19 19 19 $61.41 million 2 3 4 1.0911 1.0911 1.0911 1.0911 NPV = $61.41 million - $28.34 million = $33.07 million 13.4 Using the WACC to Value a Project Summary of WACC Method 1. 2. 3. Determine the incremental free cash flow of the investment Compute the weighted average cost of capital using Eq. 13.6 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 Cost of Capital of a New Acquisition Suppose DuPont is considering acquiring Weyerhaeuser, a company that is focused on timber, paper, and other forest products Weyerhaeuser faces different market risks than DuPont does in its chemicals business What cost of capital should DuPont use to value a possible acquisition of Weyerhaeuser? 13.5 Project-Based Costs of Capital Cost of Capital of a New Acquisition Because the risks are different, DuPont’s WACC would be inappropriate for valuing Weyerhaeuser Instead, DuPont should calculate and use Weyerhaeuser’s WACC of 8.8% when assessing the acquisition 13.5 Project-Based Costs of Capital Divisional Costs of Capital Now assume DuPont decides to create a forest products division internally, rather than buying Weyerhaeuser 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 Weyerhaeuser, then DuPont would use Weyerhaeuser’s WACC as the WACC for its new division 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). Microsoft’s 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 Microsoft’s 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? Example 13.6 A Project in a New Line of Business Solution: Plan: The first step is to identify a company operating in Microsoft’s 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 Microsoft’s proposed DVR business. Many Web sites are available that provide betas for traded stocks, including http://finance.yahoo.com. Example 13.6 A Project in a New Line of Business Solution: Plan (cont’d): Suppose you visit that site and find that the beta of TiVo stock is 1.3. 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. Example 13.6 A Project in a New Line of Business Execute: Using the CAPM, we have: Because TiVo has no debt, its WACC is equivalent to its cost of equity. Example 13.6 A Project in a New Line of Business Evaluate: The correct cost of capital for evaluating a DVR investment opportunity is 10.8%. If we had used the 8.8% cost of capital that is associated with Microsoft’s existing business, we would have mistakenly used too low of a cost of capital. That could lead us to go ahead with the investment, even if it truly had a negative NPV. Example 13.6a A Project in a New Line of Business 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? Example 13.6a A Project in a New Line of Business Solution: 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. Example 13.6a A Project in a New Line of Business Solution: Plan (cont’d): 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 .58, and its cost of debt is 3.8%. Its tax rate is 28%. Example 13.6a A Project in a New Line of Business Execute: Using the CAPM, we have: Coca Cola ' s cost of equity Risk free rate Coca Cola ' s beta Market Risk Premium 3% .4 5.4% 5.8% To get Coca-Cola’s WACC, we use equation 13.6. Coca-Cola has no preferred stock, so the WACC is: rWACC rE E% rD (1 TC )D% 5.8%(0.42) 3.8%(1 .28)(0.58) 4.02% Example 13.6a A Project in a New Line of Business Evaluate: The correct cost of capital for evaluating a beverage investment opportunity is 4.02%. 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 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 Example 13.7 Costly External Financing Problem: You are analyzing DuPont’s potential acquisition of Weyerhaeuser. DuPont plans to offer $23 billion as the purchase price for Weyerhaeuser, 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 $1.4 billion in the first year and will grow at 3% per year thereafter. What is the NPV of the proposed acquisition? Example 13.7 Costly External Financing Solution: Plan: We know from Section 13.5 that the correct cost of capital for this acquisition is Weyerhaeuser’s WACC. We can value the incremental free cash flows as a growing perpetuity: Example 13.7 Costly External Financing Solution: Plan: (cont’d) 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. Example 13.7 Costly External Financing Execute: Noting that $800 million is $0.8 billion,: Example 13.7 Costly External Financing Evaluate: It is not necessary to try to adjust Weyerhaeuser’s 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. Example 13.7a Costly External Financing Problem: You are analyzing Microsoft’s 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.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 at 3% per year thereafter. What is the NPV of the proposed acquisition? Example 13.7a Costly External Financing Solution: Plan: We know from Section 13.5 that the correct cost of capital for this acquisition is Yahoo!’s WACC. We can value the incremental free cash flows as a growing perpetuity: PV CF1 (r g ) where CF1 $1.8 billion r Yahoo!' s WACC 7.1% g 3% Example 13.7a Costly External Financing Solution: Plan: (cont’d) 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. Example 13.7a Costly External Financing Execute: NPV $44.6 1.5 1.8 $2.2 billion 0.071 .03 Example 13.7a Costly External 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. Chapter Quiz 1. 2. 3. 4. 5. Why do we use market value weights in the weighted average cost of capital? What are the major tradeoffs in using the CAPM versus the CDGM to estimate the cost of equity? Why do different companies have different WACCs? What inputs do you need to be ready to apply the WACC method? What types of additional costs does a firm incur when accessing external capital?