Fundamentals of Corporate Finance Third edition Chapter 11 The Cost of Brealey Myers Marcus Capital ndamentals of Corporate Finan Brealey Myers Marcus slides by Matthew will IrwinMcGraw-Hill CThe McGraw-Hill Companies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 11- 1 Irwin/McGraw-Hill Chapter 11 Fundamentals of Corporate Finance Third Edition The Cost of Capital Brealey Myers Marcus slides by Matthew Will Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001
11-2 Topics Covered gEothermal,s Cost of Capital S Weighted Average Cost of Capital (WACC) CApital Structure REquired rates of return SBig Oils WacC INterpreting wacc FLotation Costs Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 11- 2 Irwin/McGraw-Hill Topics Covered Geothermal’s Cost of Capital Weighted Average Cost of Capital (WACC) Capital Structure Required Rates of Return Big Oil’s WACC Interpreting WACC Flotation Costs
11-3 Cost of Capital Cost of Capital- The return the firms investors could expect to earn if they invested in securities with comparable degrees of risk Capital Structure-The firms mix of long term financing and equity financing Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 11- 3 Irwin/McGraw-Hill Cost of Capital Cost of Capital - The return the firm’s investors could expect to earn if they invested in securities with comparable degrees of risk. Capital Structure - The firm’s mix of long term financing and equity financing
11-4 Cost of Capital Example Geothermal Inc has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company cost of Capital? Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 11- 4 Irwin/McGraw-Hill Cost of Capital Example Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital?
11-5 Cost of Capital Example-Geothermal Inc has the following structure. Given that geothermal pays 8%for debt and 14% for equity, what is the Company Cost of Capital? Market Value Debt $194 30% Market Value Equity $453 70% Market Value Assets $647 100% Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 11- 5 Irwin/McGraw-Hill Cost of Capital Example - Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital? Market Value Assets $647 100% Market Value Equity $453 70% Market Value Debt $194 30%
11-6 Cost of Capital Example-Geothermal Inc has the following structure. Given that geothermal pays 8%for debt and 14% for equity, what is the Company Cost of Capital? Portfolio Return=(3x8%0)+(7x14%0)=12.2% Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 11- 6 Irwin/McGraw-Hill Cost of Capital Example - Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital? Portfolio Return = (.3x8%) + (.7x14%) =12.2%
11-7 Cost of Capital Example-Geothermal Inc has the following structure. Given that geothermal pays 8%for debt and 14% for equity, what is the Company Cost of Capital? Portfolio Return=(3x8%)+(7x14%)=12.2% Interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2%o(1.e 8%x 65) WACC=(3x52%)+(.7x149)=11.49 Irwin/McGraw-Hill CThe McGraw-Hill Companies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 11- 7 Irwin/McGraw-Hill Cost of Capital Example - Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital? Portfolio Return = (.3x8%) + (.7x14%) =12.2% Interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2% (i.e. 8 % x .65). WACC= (.3x5.2%) + (.7x14%) =11.4%
11-8 WACC Weighted Average Cost of Capital (Wacc) The expected rate of return on a portfolio of all the firm's securities Company cost of capital= Weighted average of debt and equity returns Irwin/McGraw-Hill CThe McGraw-Hill Companies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 11- 8 Irwin/McGraw-Hill WACC Weighted Average Cost of Capital (WACC) - The expected rate of return on a portfolio of all the firm’s securities. Company cost of capital = Weighted average of debt and equity returns
11-9 WACC total income assets value of investments (D X Debt)+(EXr equity assets assets B X Tdeb )+ X equil Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 11- 9 Irwin/McGraw-Hill WACC r assets (D x r ) + (E x r ) V debt equity = r assets ( x r ) ( x r ) D V debt E = + V equity rassets = total income value of investments
11-10 WACC Three Steps to Calculating Cost of capital 1. Calculate the value of each security as a proportion of the firms market value 2. Determine the required rate of return on each securi 3. Calculate a weighted average of these required returns Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 11- 10 Irwin/McGraw-Hill WACC Three Steps to Calculating Cost of Capital 1. Calculate the value of each security as a proportion of the firm’s market value. 2. Determine the required rate of return on each security. 3. Calculate a weighted average of these required returns