Chapter 2

CHAPTER TWO
VALUATION AND COST OF CAPITAL

CORPORATE FINANCE
1
Corporate Value
• Corporate or Enterprise value (EV), total
enterprise value (TEV), or firm value (FV) is an
economic measure reflecting the market value
of a business.
• It is a sum of claims by all claimants: creditors
(secured and unsecured) and shareholders
(preferred and common).
• Firm value is one of the fundamental metrics
used in business valuation, financial
modeling, accounting, portfolio analysis,
and risk analysis.
2
VALUATION ….CONT’D…
• Enterprise value is more comprehensive

than market capitalization, which only
reflects common equity.
• Importantly, EV reflects the opportunistic
nature of business and may change
substantially over time because of both
external and internal conditions.
• Therefore, financial analysts often use a
comfortable range of EV in their calculations.
3
VALUATION … C O N T ’ D
⚫ Distinction should be made

between different valuation concepts.
◦ Liquidation Value vs. Going-C oncern

Value
◦ Book Value vs. Market Value
◦ Market Value vs. Intrinsic Value
4
⚫ Liquidation Value vs Going-Concern

Value:
◦ Liquidation value is the amount of money that
could be realized if an asset or a group offassets
f
(e.g., a firm) is sold separately from its operating
organization..
◦ Going-concern value is the amount a firm could be

sold for as a continuing operating business.
5
◦ The computation of liquidation value and going-

concern value is different.
◦ Security valuation models generally assume

going-concern.
6
⚫ Book Value versus M arket Value:
◦ The book value of an asset is the accounting i
value of the asset – the asset’s cost minus its
i
accumulated depreciation.
◦ The book value of a firm is equal to the dollar

difference between the firm ’ s total assets and
its liabilities and preferred ’ stock as listed on its
balance sheet.
🞄 Book value is based on historic values and
estimations.
🞄 May not be accurate after a long period of time.
7
◦ Market value of an asset is simply the market

price at which the asset (or a similar asset) trades in
an open market place.
🞄 For a firm, market value often viewed

as being the higher of the firm’s
liquidation or going concern value.
◦ Market value often outrivals (is better than) book

value as to decision relevance.
🞄
current
Marketcash flowtakes
value into account.
risk, future opportunity,
and
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⚫M arket Value versus Intrinsic

Value:
◦ For an actively traded security,
the last
market value
reported price would
at which the be the was
security
traded.
🞄 Foran inactively traded security,
an estimated market price would be
needed
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◦ The intrinsic value of a security is what

the price off a security should be if properly
priced basedf on all factors bearing on
valuation of assets earnings, future prospects
management, and so on.
🞄 If markets are reasonably efficient

and informed, the current market price
of a security should fluctuate closely
around its intrinsic value.
10
T H E VA LUAT I O N APPRO A C H
⚫ The valuation approach adopted

here
is one determining a
of
intrinsic value.
security’s
◦ The intrinsic value

ll offfa security is the
present value ofi the cash flow stream
provided to the investor, discounted at a
required rate of return appropriate for the
risk involved..
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VA LUAT I O N APPRO A C H … C O N T ’ D
⚫ Steps Involved in Valuation:
◦ Step 1: Estimate the cash flow stream;
◦ Step 2: Identify the required rate of return
considering the timing and riskiness (or
uncertainty) of the cash flows;
◦ Step 3: Discount each cash flow into the present
value equivalent and
◦ Step 4: Sum (or aggregate) the present

values of cash flows.
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VA LUAT I O N APPRO A C H … C O N T ’ D
⚫ T hegeneral valuation model can be given by
f the llowing equation:
o
where:
🞄 V = present value of a security/claim
🞄 CF t = Expected/Future Cash Flow in Period
t
🞄 r = the required rate of return (discount 13
rate)
B O N D VALUATION
⚫ The factors that affect the valuation of a bond are the
following:
◦ Face value
◦ Coupon rate
◦ Required rate of return (Yield to Maturity -
YTM)
◦ Maturity
⚫ The M odel of B ond Valuation
or
14
B O N D VA LUAT I O N … C O N T ’ D
⚫ The yield-to-maturity (YTM) on a bond (denoted as r
or Kd in the above equation) is the expected rate of
return on a bond if it is bought at its current market
price and held to maturity.
◦ It is also known as the bond’s internal rate of

return (IRR).
⚫ YTM is the discount rate that equates the present

value of all expected interest payments and the
payment of principal (face value) at maturity with
bond’s
the current market price.
15
⚫ Valuation of bonds with a finite maturity:
⚫ Perpetual Bond – a bond that never matures,

valuation as follows:
16
⚫ Bonds with finite maturity:
Present Value of
Interest Factor
for an Annuity 17
44
⚫ G iven: Face Value of Bond $1,000, CR = 10%,YTM = 10%.
18
Figure: Time Path of the Value of a 10% Coupon $1,,000 Par
Value Bond W hen Interest Rates Are 5%, 10%, and
15%.
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EXERCISE
1
⚫A Company wants to issue 10,000 $1000-

par-value bonds with 10% coupons. The
bonds will be retired in 9 years. The
Company decides to issue the bond at
$1020. If Mr. Lemma wants to buy the
bond and his required rate of return is
8%, should he buy the bond?
20
EXERCISE
2
⚫ Suppose today is October 1, 2004. If Gift
Trading Company’s bond pays $115 every
September (i.e. on the 30th of September)
for 5 years, and in September 2009 it pays
an additional $1000 and retires the bond,
what is its value today? What is the coupon
rate on the bond? [Assume that the
required rate of return on this bond is
7.5%.]
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ZERO-COUPON B O N D
◦ A bond that pays no interest; sold at a

deep discount from its face value.
◦ Provides compensation to investors in the form

of price appreciation.
◦ The interest of a zero-coupon bond is

the remainder of the face value less issuing price.
22
ZERO-COUPON B O N D … CONT’D
⚫ The value of a zero-coupon bond

is determined as follows:
23
EXERCISE
3
⚫Suppose that Peace Enterprises issues

a zero- coupon bond having a 10-year
maturity and a $1000 face value.
Determine the bond’s value if the
investor’s required rate of return is
12%?
24
EXERCISE
4
⚫X Company issued 10,000, $1000-par-value
bonds with 10% coupons today. The bonds
will be retired in 10 years and pays interest
semiannually. Determine the value of the
bond if the yield on similar bonds is: (a)
8%, (b) 10%, and (c) 12%.
25
T H E D E T E R M I N A N T S OF
M A R K E T INTEREST
RATE
⚫ The quoted (or nominal) interest rate on a debt security,
rd is composed of a real risk-free rate of interest r* plus
several premiums that reflect inflation, the risk of the
security, and the securities marketability (or
liquidity).
where
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D E T E R M I N A N T S OF M A R K E T … C O N T ’ D
27
VALUE OF LONG -
A N D SHORT-
TERM 10%
A N N U AL
COUPON
B O N D S OF
DIFFERENT
MARKET
INTEREST RATES
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PREFERRED STO C K
VA LUAT IO N
⚫ Valuation model of a preferred stock
◦ Vp is the value of the preferred

stock,
◦ D p is the preferred dividend, and
◦ rp is the required rate of return.
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PREFERRED S TO C K … C O N T ’ D
⚫ M icroDrive has preferred stock outstanding that pays
adividend of $10 per year. If the
required
return on this rate of stock is 10 percent, then
preferred
its value is:
⚫ Given the current price of a preferred stock and

its dividend, the rate of return can be obtained as
follows:
30
⚫ Some preferred stocks have a stated maturity date –

in this case, the valuation formula is similar to that
of bond.
⚫ Most preferred stocks pay dividends quarterly.
◦ The effective rate of return on the preferred

stock need to be determined for comparison.
31
⚫I MicroDrive pays dividend quarterly, the effective
forate f return on its preferred
stock (perpetual
maturing) as or
follows:
where m = number of payments made in a year

⚫ To compare the returns on bonds and preferred stock,
it would be best to convert the nominal rates on each
security to effective rates and then compare these
“equivalent annual rates ”
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C O M M O N STO C K VA LUAT I O N
⚫ Common stock is a security that represents
the ultimate ownership (and risk) position in a
corporation.
⚫ Valuation of common stock is difficult due to:
◦ uncertainty,
◦ payment of stock dividend,
◦ different risk levels, etc.
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C O M M O N S TO C K … C O N T ’ D
⚫ S tockprices are determined as the present

value of a stream of cash flows.
◦ Basic stock valuation equation is similar to the

bond valuation equation.
⚫ Common stock investors receive a stream of

dividends, and the value of the stock today is
calculated as the present value of an infinite
stream of dividends.
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⚫ Valuation of Stock (Formula):
35
⚫ Valuation Issues:
◦ Investors may hold the stock for a

short or long period
◦ Dividend might be constant (no growth)
◦ Constant growth dividend
◦ Super normal growth (different growth
phases)
⚫ Terminologies.docx 36
⚫ W hen investors hold the stock for a long
period, value (reflected in price)
determined as follows:
⚫ When investors hold the stock for a short period,

value would be determined as follows:
where D 1, D 2, … D n, and Pn are all

estimates 37
⚫ Companies sometimes may not pay

dividend on their outstanding common
stocks.
⚫ Question:
◦ Why do the stocks of companies that pay no

dividends have positive, often quite high,
values?
38
◦ Investors expect to sell the stock in the future
at a price higher than they paid for it.
◦ Terminal value depends on the expectations of

the marketplace viewed from the terminal
point.
◦ The ultimate expectation is that the firm will

eventually pay dividends either regular or
liquidating, and that future investors will
receive a company-provided cash return on
their investment. 39
N O G R O W T H S TO C K
◦ Assume that dividends will be maintained at
their current level forever (a kind of dividend
policy).
◦ Since D 1 = D 0 for no growth stock, the formula

would simply be as follows:
rs = minimum acceptable,
or required, rate of
return 40
C O N S TA N T G R O W T H S TO C K
⚫ Infinite period
◦ Assume that dividends grow at a constant rate.
◦ The constant growth model (the Gordon model

after Myron JJJJ. Gordon who developed this model)
◦ Assume that D 0 is the present dividend per share

and g is the growth rate of dividend, so D 1 is
(1+g)D0, D 2 is D0(1+g)2,…Dn is D0(1+g)n.
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C O N S TA N T G R O W T H … C O N T ’ D
⚫ Accordingly constant growth stock is

valuated as:
where:
D 1 = next period/year dividend,
and g < rs
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C O N S TA N T G R O W T H … C O N T ’ D
⚫ Formula
:
⚫g can never be larger than

rs.Why?
4
3
EXAMPLE
⚫ Assume that MicroDrive just paid a dividend of $1.15 (i.e.,
D 0 = $1.15). Its stock has a required rate of return,
rs, of
13.4 percent, and investors expect the dividend to grow
at a constant 8 percent rate in the future. The estimated
dividend one year hence would be D 1 = $1.15(1.08) =
$1.24; D 2 would be $1.34; and the estimated dividend
five years hence would be:
⚫ Thestock’s intrinsic value (P0) assuming dividend grows at

8% forever would be:
44
⚫ Figure
depicts the
concept
underlying the
valuation
process for
a constant
stock (where
growth
dividends are
growing at the
g = 8%, but
because rs > g,
the present
value of each
future dividend
is declining).
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⚫ Dividends and Earnings Growth
◦ Growth in dividends occurs primarily as a result of
growth in earnings per share (EPS).
◦ Earnings growth, in turn, results from a number
of
factors, including:
🞄 (1) inflation,
🞄 (2) the amount of earnings the
company retains and reinvests, and
🞄 (3) the rate of return the
company earns on its equity (ROE).
46
When Can the Constant Growth Model Be
Used?
⚫ It is appropriate for mature companies with a
stable history of growth.
⚫ Dividend growth for most mature firms is generally
expected to continue in the future at about the same
rate as nominal gross domestic product (real GDP
plus inflation).
◦ One might expect the dividends of an average, or

“normal,” company to grow at a rate of 5 to 8
percent a year. 47
75
⚫ D istinguish between the following:
◦ = minimum acceptable, or required, rate

of return on the stock, considering both its
riskiness and the returns available on other
investments
◦ =expected rate of return that an investor

who buys the stock expects to receive in the
future
◦ = actual, or realized, after-the-fact rate of

return 48
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⚫ E xpected
Rate of Return on a Constant
Growth Stock:
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⚫ If you buy a stock for a price P0 = $23, and if you
expect the stock to pay a dividend D 1 = $1.242 one
year from now and to grow at a constant rate g = 8%
in the future, then your expected rate of return will
be:
⚫ is the expected total return and that it consists

of:
◦ an expected dividend yield, D 1/P0 = 5.4%, plus
◦ an expected growth rate or capital gains yield, g = 50
50
8%.
⚫ Suppose the above analysis had been conducted on

January 1, 2003, so P0 = $23 is the January 1, 2003,
stock price, and D 1 = $1.242 is the dividend expected
at the end of 2003. What is the expected stock
price at the end of 2003?
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⚫ N otethat $24.84 is 8 percent larger than P0, the
p$23 rice on January 1, 2003:
⚫ Thus, we would expect to make a capital gain

of
$24.84 – $23.00 = $1.84 during 2003, which
would provide a capital gains yield of 8 percent:
⚫ In each future year, the expected capital gains yield

would always equal g, the expected dividend growth
rate.
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⚫ The dividend yield in 2004 could be estimated as follows:
⚫ Thedividend yield for 2005 again would be 5.4

percent.
⚫ Thus,
for a constant growth stock, the ff conditions
must hold:
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C O N S TA N T G R O W T H M O D E L
( C O N V E R S I O N TO A N EARNINGS
MULTIPLIER APPROACH)
⚫ Assume that a company retains a constant
proportion
(b) of its earnings (E) each year.Then,
Note that: V = D1/(r – g)
⚫ We need to know earnings multiplier because it

brings together value and earnings of a stock.
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N O N C O N S TA N T G R O W T H RATE
⚫ For many companies, it is inappropriate to

assume that dividends will grow at a constant
rate.
⚫ Firms typically go through life cycles.
◦ During the early part of their lives, their

growth is much faster than that of the
economy as a whole;
◦ Then, they match the economy’s growth; and
◦ Finally, their growth is slower than that of

the economy. 55
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⚫ Examples:
🞄 Microsoft, Corporation
🞄 Internet Firms
🞄 Social N etworks (like Facebook C ompany)

⚫ These firms are called supernormal,
or nonconstant, growth firms.
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⚫ For nonconstant growth scenario, we need to
modify the equation used for constant growth
situation.
◦ We may assume that a company currently enjoying
supernormal growth will eventually slow down and
become a constant growth stock.
◦ First, we assume that the dividend will grow at a
nonconstant rate (generally a relatively high rate)
for N periods, after which it will grow at a constant
rate, g.
◦ N is often called the terminal date, or
horizon date
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⚫ We can use the constant growth formula to

determine what the stock’s horizon, or terminal,
value will be N periods from today:
⚫ The stock’s intrinsic value today, ˆP0,, is the

ll
present value of the dividends during the
f
nonconstant growth period plus the present value of
the horizon value:
58
⚫ The following three steps

followed:
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EXAMPLE
⚫ Consider the following information:
◦ Stockholders’ required rate of return (rs) =
13.4%. This rate is used to discount the cash flows.
◦N = years of supernormal growth = 3.
◦ gs = rate of growth in both earnings and
dividends during the supernormal growth period
30%.
◦ gn = rate of normal, constant growth after
the supernormal period 8%.
◦ D 0 = last dividend the company paid = $1.15.
⚫ What is the intrinsic value of the stock today?
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PRO C E S S FOR F I N D I N G T H E VA LUE OF
A S U P E R N O R M A L G R O W T H S TO C K
⚫ The value of the supernormal growth stock

is calculated to be $39.21.
Valuation (Exercise).doc
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THE CONCEPT AND
D E T E R M I N AT I O N
OF C O S T OF
CAPITAL
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C O S T OF CAPITAL
⚫ The concept of cost of capital has its roots in
the items on the right-hand-side of the balance
sheet, which includes various types of:
◦ debt,
◦ preferred stock,
◦ common stock, and
◦ retained earnings.
⚫ These items are called the capital components.
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C O S T OF C A P I TA L … C O N T ’ D
⚫ An increase in total asset must be financed by an

increase in one or more of these capital components.
⚫ Capitalis one of the necessary components of

production/operation of a business firm.
◦ Like any other factor it has a cost of its own.
⚫ Most firms employ different types of capital, and,

due to differences in risk, these different securities
have different required rates of return.
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◦ The required rate of return on each capital
component is called its component cost (specific
cost).
◦ The cost of capital used to analyze capital

budgeting decisions should be a weighted average
of the various components’ costs – called the
weighted average cost of capital, or W A C C .
⚫ Most firms set target percentages for the

different financing sources - called target capital
structure.
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C O S T OF CAPITAL … C O N T ’ D
⚫A company might issue common stock one

year, debt in the next, and preferred stock
the following year, thus fluctuating around
its target capital structure.
◦ Caution: this can cause managers to make a

serious error in selecting projects during capital
budgeting process.
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⚫ Managers should view companies as

going concerns.
◦ Therefore, managers should calculate their

costs of capital as weighted averages of the
various types of funds they use, regardless of the
specific source of financing employed in a
particular year.
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C O S T OF D E B T
⚫ Thefirst step in estimating the cost of debt is
to determine the rate of return debtholders
require – rd.
◦ The WACC is used primarily to make

investment decisions.
◦ These decisions hinge on projects’ expected

future returns versus the cost of new, or
marginal, capital
⚫ Therelevant cost is the marginal cost of new

debt to be raised during the planning period. 6868
C O S T OF D E B T … C O N T ’ D
◦ The required return to debtholders, rd, is not
equal to the company’s cost of debt because, since
payments
interest are deductible, thegovernment in
effect pays part of the total cost.
◦ The cost of debt to the firm is less than the rate

of return required by debtholders..
⚫ The after-tax cost of debt is used to calculate

the WACC, and it is the interest rate on debt, rd,
less the tax savings that result because interest is
deductible.
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C O S T OF D E B T … C O N T ’ D
⚫ If a firm can borrow at an interest rate of 11

percent, and if it has a marginal federal-plus-
state tax rate of 40 percent, then its after-tax
cost of debt is:
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C O S T OF PREFERRED S TO C K
⚫ Firmsuse preferred stock as part of their
permanent financing mix.
◦ Preferred dividends are not tax deductible.
◦ The company bears their full cost, and no tax

adjustment is used when calculating the cost of
preferred stock.
⚫ Thecomponent cost of preferred stock (rps) is

used to calculate the weighted average cost
of capital.
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C O S T OF PREFERRED… C O N T ’ D
⚫ rps,is the preferred dividend, Dps, divided by

the net issuing price, Pn, which is the price the
firm receives after deducting flotation costs.
◦ Flotation costs are higher for preferred stock than

for debt, hence they are incorporated into the
formula for preferred stocks’ costs.
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C O S T OF PREFERRED… C O N T ’ D
⚫ Assume that X Company has preferred stock that

pays a $10 dividend per share and sells for $100
per share. If the Company issued new
shares of preferred, it would incur an
underwriting (or flotation) cost of 2.5 percent, or
$2.50 per share, so it would net $97.50 per share.
The Company’s cost of preferred stock is :
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C O S T OF C O M M O N S TO C K
⚫ Companies can raise common equity in two

ways:
◦ (1) directly by issuing new shares, and

◦ (2) indirectly by retaining earnings.
⚫ Ifnew shares are issued, what rate of return must

the company earn to satisfy the new
stockholders?
◦ Investors require a return of rs.

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C O S T OF C O M M O N … C O N T ’ D
⚫ However, a company must earn more than rs on new
external equity to provide this rate of return to
investors because there are commissions and fees,
called flotation costs, when a firm issues new equity.
⚫ Few mature firms issue new shares of common stock.
Only small amount of all new corporate funds comes
from external equity market for the following 3
reasons:
◦ (i) Flotation costs (includingregistration)

can be quite high.
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◦ (ii) Investors perceive issuing equity
s as a negative ignal with respect to
the true
stock. value of believe
Investors the company’s that managers have
superior knowledge about companies’ future prospects,
and that managers are most likely to issue new stock
when they think the current stock price is higher than
the true value.
🞄 If a mature company announces plans to issue
additional shares, this typically causes its stock price
to decline.
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⚫(iii) An increase in the supply of stock will put

pressure on the stock’s price, forcing the company
to sell the new stock at a lower price than existed
before the new issue was announced.
⚫ So, we may assume that companies do not
plan to issue new shares.
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⚫ D oes new equity capital raised indirectly
by retaining earnings have a cost?
◦ Yes – if some of its earnings are retained, then

stockholders will incur an opportunity cost.
◦ The earnings could have been paid out as
dividends (or used to repurchase stock), in which
case stockholders could then have reinvested the
money in other investments.
◦ The firm should earn on its reinvested earnings at
least as much as its stockholders themselves could
earn on alternative investments of equivalent risk.
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⚫ Whatrate of return can stockholders expect to
earn on equivalent-risk investments?
◦ It is rs, because they expect to earn that return by
simply buying the stock of the firm in question or
that of a similar firm.
◦ rs is the cost of common equity raised internally by
retaining earnings.
◦ If a company cannot earn at least rs on reinvested
earnings, then it should pass those earnings on to
its stockholders and let them invest the money
themselves in assets that provide rs.
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⚫ Three methods are used to estimate cost of
equity:
◦ (1) the Capital Asset Pricing Model (CAPM),
◦ (2) the Discounted Cash Flow (DCF) method, and
◦ (3) the Bond-Yield-plus-Risk-Premium approach.

⚫ These methods are not mutually exclusive—no
method dominates the others, and all are subject to
error when used in practice.
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T H E C A P M APPRO A C H
⚫ T his approach involves the following steps:
◦ Step 1. Estimate the risk-free rate, rRF.. … it is equal
to the rate on long-term treasury bond
◦ Step 2. Estimate the current expected market
risk premium, RPM .
🞄 RPM is the expected market return (rM) minus the
risk- free rate (rRF)
🞄 If the market is in equilibrium,

the expected market return is
equal to the required return:rM = rM:
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C A P M … CONT’D
◦ Step 3. Estimate the stock’s beta coefficient, bi, and
use it as an index of the stock’s risk
company’s
(the i beta).
signifiesthe ith
◦ Step 4. Substitute the preceding values into the

C APM equation to estimate the required rate of return
on the stock in question:
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C A P M … CONT’D
⚫ The CAPM estimate of rs begins with the risk-free
rate, rRF, to which is added a risk premium set equal
to the risk premium on the market, RPM, scaled up
or down to reflect the particular stock’s risk as
measured by its beta coefficient.
⚫ Assume that rRF = 8%, RPM = 6%, and bi = 1.1,
indicating that the Company is somewhat riskier than
average.Therefore, the Company’s cost of equity is:
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D I S C O U N T E D C A S H F L O W (DCF)
APPROACH
⚫ Also called the Dividend-Yield-plus-Growth-
Rate
approach.
⚫ Ifdividends are expected to grow at a constant rate,
then the price of a stock is:
⚫ We can solve for rs to obtain the required rate of return

on common equity, which for the marginal investor is
also equal to the expected rate of return:
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DISCOUNTED CASH F L O W … CONT’D
⚫ Investorsexpect to receive a dividend yield, D1/P0,

plus a capital gain, g, for a total expected return of
rs.
◦ In equilibrium, this expected return is also equal
to the required return, rs.
⚫ Suppose a firm’s stock sells for $32; its next
expected dividend is $2.40; and its expected
growth rate is 7 percent. The firm’s expected and
required rate of return, hence its cost of common
stock, would then be
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BOND-YIELD-PLUS-RISK-PREMIUM
APPROACH
⚫ Some analysts use a subjective, ad hoc
estimate
procedure
a firm’s to
cost of common equity: they simply add
a judgmental risk premium of 3 to 5 percentage points
to the interest rate on the firm’s own long-term debt.
⚫ Firms with risky, low-rated, and consequently high-
interest- rate debt will also have risky, high-cost equity,
and the procedure of basing the cost of equity on a
readily observable debt cost utilizes this logic.
⚫ Because the risk premium is a judgmental estimate, the

estimated value of rs is also judgmental.
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86
W E I G H T E D AVERA G E C O S T
OF CAPITAL ( WA C C )
⚫ Eachfirm has an optimal capital structure, defined
as that mix of debt, preferred, and common
equity that causes its stock price to be
maximized.
⚫A value-maximizing firm will establish a target (optimal)
capital structure and then raise new capital in a
manner that will keep the actual capital structure
on target over time.
◦ The target proportions of debt, preferred stock, and
common equity, along with the component costs of
capital, are used to calculate the firm’s WAC C .
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87
EXAMPLE
⚫ Suppose a firm has a target capital structure calling for 30
percent debt, 10 percent preferred stock, and 60
percent common equity. Its before-tax cost of debt, rd,
is 11 percent; its after-tax cost of debt is rd(1–T) =
11%(0.6) = 6.6%; its cost of preferred stock, rps, is 10.3
percent; its cost of common equity, rs, is 14.5 percent; its
marginal tax rate is 40 percent; and all of its new equity
will come from retained earnings. The WAC C , of the
firm can be calculated as follows:
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88
W A C C - C O N S I D E R AT I O N S
⚫ (1)
the W A C C is the weighted average cost of each
new, or marginal, dollar of capital—it is not the
average cost of all dollars raised in the past.
◦ We are primarily interested in obtaining a cost of
capital to use in discounting future cash flows, and
for this purpose the cost of the new money that will
be invested is the relevant cost.
◦ On average, each of these new dollars will consist of
some debt, some preferred, and some common
equity.
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W A C C C O N S I D E R AT I O N S … C O N T ’ D
⚫ (2) the percentages of each capital component,
called weights, could be based on:
◦ (1) accounting values as shown on the B/S (book
values),
◦ (2) current market values of the capital components or
◦ (3) management’s target capital structure, presumably an
estimate of the firm’s optimal capital structure.
🞄 The correct weights are those based on the
ii structure, since this is the best
firm’s target capital
estimate of how thei firm will, on average, raise
money in the future.
🞄 Some survey evidence indicates that the
majority of firms do base their weights on target9090
capital structures, and that the target structures reflect
market values.
FA C TO R S T H AT AFFECT T H E
W AC C
⚫ Factors the Firm Cannot Control
◦ (1) the level of interest rates,
◦ (2) the market risk premium, and
◦ (3) tax rates.
⚫ Factors the Firm Can Control
◦ (1) its capital structure policy,
◦ (2) its dividend policy, and
◦ (3) its investment (capital budgeting)
policy.
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ADJUSTING T H E C O S T
CAPITAL
OF FOR FLOTATION C O S T S
⚫ Flotation Costs and the Component Cost of Debt
where
◦ M is the bond’s par value,
◦ F is the flotation percentage,
◦ N is the bond’s maturity,
◦ T is the firm’s tax rate,
◦ INT is the dollars of interest per period, and
◦ rd is the after-tax cost of debt adjusted for
flotation. 92
FLOTATION C O S T S … C O N T ’ D
⚫ Cost of Newly Issued Common Stock, or External
Equity, re
◦ The cost of new common equity, re, or external
equity, is higher than the cost of equity raised
internally by reinvesting earnings, rs becausef of
flotation costs involved in issuing new commonf stock.
⚫ The cost of new common stock is obtained as
follows:
where F is the percentage flotation cost incurred in

selling the new stock, and P0(1-F) is the net price
93
per share received by the company.
S O M E PRO B L E M A R E A S I N
C O S T OF CAPITAL
⚫ Difficult
issues relate to the determination offf cost
f
of capital.The difficulty relate to the following:
◦ Privately owned firms
◦ Small businesses
◦ Measurement problems
◦ Costs of capital for projects of differing riskiness
◦ Capital structure weights
94
FOU R MISTA K E S TO AVO I D
⚫ (1) Never use the coupon rate on a firm’s

existing debt as the pre-tax cost of debt – the
relevant pre-tax cost of debt is the interest rate
the firm would pay if it issued debt today..
⚫ (2) When estimating the market risk

premium for the C A P M method (Capital-
Asset-Pricing-Model), never use the
historical average return on stocks in
conjunction with the current risk-free rate –
use the current risk premium..
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95
FO U R MISTA K E S TO AVO I D … C O N T ’ D
⚫ (3) Never use the book value of equity when

estimating the capital structure weights for
the W AC C – use market value weights.
⚫ (4) Always remember that capital
components are funds that come from
investors.
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END
97

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CHAPTER TWO

VALUATION AND COST OF CAPITAL

• Enterprise value is more comprehensive

⚫ Distinction should be made

◦ Liquidation Value vs. Going-C oncern

◦ Book Value vs. Market Value

◦ Market Value vs. Intrinsic Value

⚫ Liquidation Value vs Going-Concern

◦ Going-concern value is the amount a firm could be

◦ The computation of liquidation value and going-

◦ Security valuation models generally assume

◦ The book value of a firm is equal to the dollar

◦ Market value of an asset is simply the market

🞄 For a firm, market value often viewed

◦ Market value often outrivals (is better than) book

⚫M arket Value versus Intrinsic

◦ The intrinsic value of a security is what

🞄 If markets are reasonably efficient

⚫ The valuation approach adopted

◦ The intrinsic value

◦ Step 4: Sum (or aggregate) the present

◦ It is also known as the bond’s internal rate of

⚫ YTM is the discount rate that equates the present

⚫ Perpetual Bond – a bond that never matures,

⚫A Company wants to issue 10,000 $1000-

◦ A bond that pays no interest; sold at a

◦ Provides compensation to investors in the form

◦ The interest of a zero-coupon bond is

⚫ The value of a zero-coupon bond

⚫Suppose that Peace Enterprises issues

◦ Vp is the value of the preferred

⚫ Given the current price of a preferred stock and

⚫ Some preferred stocks have a stated maturity date –

⚫ Most preferred stocks pay dividends quarterly.

◦ The effective rate of return on the preferred

where m = number of payments made in a year

⚫ Valuation of common stock is difficult due to:

◦ payment of stock dividend,

◦ different risk levels, etc.

⚫ S tockprices are determined as the present

◦ Basic stock valuation equation is similar to the

⚫ Common stock investors receive a stream of

⚫ Valuation of Stock (Formula):

◦ Investors may hold the stock for a

⚫ When investors hold the stock for a short period,

where D 1, D 2, … D n, and Pn are all

⚫ Companies sometimes may not pay

◦ Why do the stocks of companies that pay no

◦ Terminal value depends on the expectations of

◦ The ultimate expectation is that the firm will

◦ Since D 1 = D 0 for no growth stock, the formula

◦ Assume that dividends grow at a constant rate.

◦ The constant growth model (the Gordon model

◦ Assume that D 0 is the present dividend per share

⚫ Accordingly constant growth stock is

⚫g can never be larger than

⚫ Thestock’s intrinsic value (P0) assuming dividend grows at

◦ One might expect the dividends of an average, or

◦ = minimum acceptable, or required, rate