Unit 6 WACC

Required Returns and Cost
of Capital
Unit six
Chapter 14
Value Creation
 Industry Attractiveness
 In the long run profits are largely determined by the industry structure
 Five forces of the industry: Power of Buyers, Power of Suppliers, Threat of
Substitutes, Degree of Rivalry and Threat of New Entrants
 Competitive Advantage
 Advantage gained over competitors by offering customers greater value,
either through lower prices or by providing additional benefits and service
that justify similar, or possibly higher, prices.
Weighted Average Cost of Capital (WACC)
 Required return/ appropriate discount rate/ cost of capital

 Positive NPV if return is greater then require rate of return
 Minimum require return to compensate its investors for the use of
the capital needed to finance the project
 Cost of capital for a risk-free investment is the risk-free rate
 The cost of capital depends primarily on the use of the funds,
not the source
 Source (debt and or equity), use (riskiness of the project)
Calculation of WACC
 COST OF EQUITY
 DIVIDEND GROWTH MODEL APPROACH re= D1 / P0 + g
 SML APPROACH re = Krf + (Krm – Krf ) be
 COST OF DEBT = yield to maturity (YTM) of debt after tax
 COST OF PREFERRED STOCK rp= D / P0
 WACC
 WACC = (E/V )* re + (P/V )* R p + (D/V ) * R d *(1 - T c )
Marginal Cost of Capital
 New fund (new debt, new preference share, new equity

 Cost to raise one additional dollar of new capital from different
sources
 Rate of return that shareholders and debt holders expect before
making an investment in a company
 The marginal cost of capital usually goes up as the company raises
more capital.
 This is because capital is a scarce resource
MCC
 Does not increase linearly
 Some part of fund requirement comes from Retain earning and additional fund
raised from external source
 MCC increases due to external source of fund
 Component of cost of capital
 Marginal cost of debt = Kd (1-tax)
 Marginal cost of equity (expected dividend growth rate plus the ratio of dividend for
next year to the company’s stock price, adjusted for the cost of stock issuance)
 MCE = [D1/(P0 * (1-issuance cost)]+ Expected Dividend growth rate
Example -MCC
 Interest rate on new debt= 7% , tax rate is 15%.
 The marginal cost of debt= 0.07*(1-0.15)= 5.95%.
 Issuance cost =10%, current price= $30, expected dividend growth rate is 5%,
dividend for the next year is $2
 Adjusted stock price or net proceed = $30*(1-0.10) = $27.
 The marginal cost of common stock capital =($2/$27)+5% =12.40%.
 the marginal cost of preferred stock capital (dividend rate 5%) = 5%
 WEIGHTED MARGINAL COST OF CAPITAL
 IF new debt= 20%, equity = 50% and preference share =30%
 WMCC= (20%*5.95%)+(50%*12.40%)+(30%*5%)= 10.13%.
Adjusting Cost of Capital for Risk
 WACC reflects the average risk and overall capital structure of the entire firm.
 No adjustments are needed when using the WACC as the discount rate for the firm
 Adjustments for risk are often needed when evaluating a division or project
Firm with two division WACC New Project (ERR) Decision

Bakery low risk 10% 11% Accept
Café high risk 14% 13% Reject
Overall 12% Reject bakery's project accept café'

project
 Watch the video: https://www.youtube.com/watch?v=kvBe0F801LY

Divisional cost of capital
 Firm uses CAPM (SML) Ks = Krf +(RPm)bi
Krf RPm Beta Ks Weight
Division A 5 6 1.10 11.60 0.7
Division B 5 6 1.50 14.00 0.2
Division C 5 6 0.50 8.00 0.1
Over all 5 6 1.12 11.72 1.0
 Measuring Divisional Betas

 The Pure Play Method (based on average of public specialized company)
 The Accounting Beta Method (regression of the division’s return on assets against the average return
on assets for a large sample of firms)
 Estimating the Cost of Capital for Individual Projects
 Stand-alone risk (variability of project’s expected return)
 Corporate, or within-firm (variability the project contribute to firm’s returns)
 Market, or beta, risk (risk of the project seen by well diversified stockholder)
Economic Value Added (EVA)
 Managerial effectiveness in a given year

 EVA= Net operating profit after taxes (NOPAT)-After-tax dollar cost of capital used to
support operations
=EBIT (1- Tax rate)- (Total net operating capital * WACC)
= (Operating capital) (ROIC - WACC)
 ROIC = NOPAT / Operating capital
 ROIC = return on invested capital = 14% or 10%
 WACC= 12%
 EVA will be positive (ROIC> WACC)
 EVA will be negative (ROIC< WACC)
Example 1 EVA
 A firm has $100 million in total net operating capital. Its return on invested capital is 14%,
and its weighted average cost of capital is 10%. What is its EVA?
 Solution: EVA = (Operating capital) (ROIC - WACC)
100 million *(0.14-0.10) = 4 million
Example 2 EVA
 Last year Cole Furnaces had $5 million in operating income (EBIT). The company had a
net depreciation expense of $1 million and an interest expense of $1 million; its corporate
tax rate was 40%. The company has $14 million in operating current assets and $4 million
in operating current liabilities; it has $15 million in net plant and equipment. It estimates
that it has an after-tax cost of capital of 10%. Assume that Cole’s only noncash item was
depreciation.
Calculate net operating working capital and total net operating capital for the current year.
What was the company’s Economic Value Added (EVA)?
Solution
NOWC = Operating current assets − Operating current liabilities

= (Cash + Accounts receivable + Inventory) − (Accounts payable + Accruals) = $14000000 −
$4000000 = $10;000;000
Total net operating capital = NOWC +Operating long term assets

= $10000000 + $15000000 = $25000000
EVA = EBIT (1 − T) − (Total capital)(After-tax cost of capital)

= $5000000 (0.6)− ($25000000)(0.10)= $3000000 − $2500000 = $500000
Problem
 try these sum for next class discussion 1 to 10

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Required Returns and Cost

 Required return/ appropriate discount rate/ cost of capital

 New fund (new debt, new preference share, new equity

Firm with two division WACC New Project (ERR) Decision

Overall 12% Reject bakery's project accept café'

 Watch the video: https://www.youtube.com/watch?v=kvBe0F801LY

 Measuring Divisional Betas

 Managerial effectiveness in a given year

NOWC = Operating current assets − Operating current liabilities

Total net operating capital = NOWC +Operating long term assets

EVA = EBIT (1 − T) − (Total capital)(After-tax cost of capital)

 try these sum for next class discussion 1 to 10

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