Principles of Corporate Finance
Professor James J. Barkocy
McGraw-Hill/Irwin
Copyright © 2015 by The McGraw-Hill Companies, Inc. All rights reserved.
All Equity Identities
Value of
Business
Risk of
Business
Rate of Return
on Business
Required Return
From Business
=
=
=
=
Value of
Stock
Risk of
Stock
Rate of Return
on Stock
Required Return
From Stock
2
Cost of Capital
Capital Structure - The
firm’s mix of long term
financing and equity
financing.
Cost of Capital - The
return the firm’s investors
could expect to earn if
they invested in securities
with comparable degrees
of risk.
3
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%
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?
Cost of Capital = (.3x8%) + (.7x14%) = 12.2%
5
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.
6
WACC
V= D+E
rassets   x rdebt    x requity 
D
V
E
V
7
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.
8
WACC
 Taxes are an important consideration in the company cost of
capital because interest payments are deducted from income
before tax is calculated.
After-tax cost of debt = pretax cost x (1-tax rate)
= rdebt x (1 - Tc)
9
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 = (.3x(1-.35)x8%) + (.7x14%) = 11.4%
10
WACC
Weighted -average cost of capital=
D
 E

WACC =   (1 - Tc )rdebt  +   requity 
V
 V

11
WACC
Example - Executive Fruit has
issued debt, preferred stock and
common stock. The market value of
these securities are $4 mil, $2mil, and
$6mil, respectively. The required
returns are 6%, 12%, and 18%,
respectively.
Q: Determine the WACC for
Executive Fruit, Inc.
12
WACC
Example - continued
Step 1
Firm Value = 4 + 2 + 6 = $12 mil
Step 2
Required returns are given
Step 3
WACC =
[
4
12
] (
x(1-.35).06 +
2
12
) (
x.12 +
6
12
)
x.18
=.123 or 12.3%
13
Check the Logic
WACC = (.3x(1-.35)x8%) + (.7x14%) = 11.4%
14
Measuring Capital Structure
 In estimating WACC, do not use the Book Value
of securities.
 In estimating WACC, use the Market Value of
the securities.
 Book Values often do not represent the true
market value of a firm’s securities.
15
Measuring Capital Structure
Market Value of Bank Loans – floating
rate, so book value is a fair approximation.
Market Value of Bonds - PV of all coupons
and par value discounted at the current
interest rate. (PV times # of bonds)
Market Value of Equity - Market price per
share multiplied by the number of
outstanding shares.
16
Required Rates of Return
Bonds
rdebt = YTM
Common Stock
requity = CAPM
= rf + B(rm - rf )
17
Required Rates of Return
Dividend Discount Model Cost of Equity
Perpetuity Growth Model =
Div1
P0 =
re - g
solve for re
requity
[ ]
Div1
=
+g
P0
18
Required Rates of Return
Expected Return on Preferred Stock
Price of Preferred Stock =
P0 =
Div1
rpreferred
solve for preferred
19
Capital Budgeting
 Valuing a Business
The value of a business or project is usually computed as the
discounted value of FCF out to a valuation horizon (H).
 Free cash flows are our operating cash flows less investment in plant
and working capital. The valuation horizon is sometimes called the
terminal value and is calculated like Present Value of Growth
Opportunities.

PV 
FCF1
FCF2
FCFH
PVH


...


(1  WACC )1 (1  WACC ) 2
(1  WACC ) H (1  WACC ) H
20
Capital Budgeting
 Valuing a Business or Project
PV 
FCF1
FCF2
FCFH
PVH


...


(1  WACC )1 (1  WACC ) 2
(1  WACC ) H (1  WACC ) H
PV (free cash
flows)
PV (horizon
value)
21
Capital Budgeting
Example - Concatenator Manufacturing
 79.5 
Horizon Value)  
  2,271.40
 .085  .05 
73.6
87.1
102.9
34.1
40.2
2,271.40
PV(FCF)  




2
3
4
5
1.085 1.085 1.085 1.085 1.085 1.0855
 1,290.40
22