# lecure WACC notes summary.pdf

29. May 2023
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### lecure WACC notes summary.pdf

• 1. 11/17/2022 Cost of Capital Financial management and control systems (Lecture 2) Dr. Mahmoud Otaify Assistant Professor of Finance 2 LO1 Understand the basic concept of cost of capital LO2 Determine a firm’s cost of equity capital. LO3 Determine the cost of long-term debt LO4 Calculate the weighted average cost of capital (WACC) Dr. Mahmoud Otaify - FMCS: Cost of Capital 1 2
• 2. 11/17/2022 3 Weight Amount \$ Source E/V=600,000/1000,000=0.6 600,000 Common Stocks (E) P/V=150,000/1000,000=0.15 150,000 Preferred Stock (P) D/V=250,000/1000,000=0.25 250,000 Bonds (D) 1 1,000,000 Total value of capital structure (V=E+P+D) How Much? % Symbol Cost of Capital SML RE Cost of Equity DDM RP Cost of Preferred YTM RD Pre-tax cost of Debt Dr. Mahmoud Otaify - FMCS: Cost of Capital Owners + Creditors Require rate of return Company Use funds to receive more than cost of funds Dr. Mahmoud Otaify - FMCS: Cost of Capital 4 3 4
• 3. 11/17/2022 Debt Financing • If you want to finance project from banks and bank requires 10% as interest (return), the cost of debt capital is 10% • Firm must earn at least 10% to pay the interest payment. Equity Financing • If you want to finance project from capital market and investors require 8% return, the cost of equity capital is 8%. • Firm must earn at least 8% to compensate investors for the use of the capital needed to finance the project. Cost of Debt Capital • The return that lenders require on the firm's debt. Cost of Equity Capital • The return that equity investors require on their investment in the firm. 5 Dr. Mahmoud Otaify - FMCS: Cost of Capital 5 6
• 4. 11/17/2022 Expected return on the market – risk-free rate of return Dr. Mahmoud Otaify - FMCS: Cost of Capital 7 E(RM) = 17% RF=12% Beta = 1.2 RE=? RE = 12%+ (17% - 12%) = 17% RE = 12%+ 1.2*(17% - 12%) = 18% E(RM) – RF = 17 – 12 = 5% CAPM Dr. Mahmoud Otaify - FMCS: Cost of Capital 8 7 8
• 5. 11/17/2022 Cost of Common Stock (SML) 9 Compute cost of equity using the SML Risk-free rate, Rf Market risk premium, E(RM) – Rf Systematic risk of asset,  ) ) ( ( f M E f E R R E R R     Example: Company’s equity beta = 1.2 Current risk-free rate = 7% Expected market risk premium = 6% What is the cost of equity capital? % 2 . 14 ) 6 ( 2 . 1 7 RE    Dr. Mahmoud Otaify - FMCS: Cost of Capital 9 10
• 6. 11/17/2022 Cost of Preferred Stocks (Rp) 11  Reminders  Preference shares generally pay a constant dividend every period.  Dividends are expected to be paid every period forever.  Preference share valuation is an annuity, so we take the annuity formula, rearrange and solve for RP.  RP = D/P0  Example  Your company has preference shares that have an annual dividend of \$3. If the current price is \$25, what is the cost of a preference share? RP = 3 / 25 = 12% Dr. Mahmoud Otaify - FMCS: Cost of Capital 11 12
• 7. 11/17/2022 Risk- free rate Credit Risk Premiu m Required Return by Bondholders A bond’s rating is used to indicate its relative probability of default Yield on Treasury Securities Dr. Mahmoud Otaify - FMCS: Cost of Capital 13 Dr. Mahmoud Otaify - FMCS: Cost of Capital 14 The cost of debt = the required return on a company’s debt. Compute the yield to maturity on existing Bond 𝒀𝑻𝑴 = 𝑪𝒐𝒖𝒑𝒐𝒏 + 𝑭𝑽 − 𝑩𝑽 𝑴𝒂𝒕𝒖𝒓𝒊𝒕𝒚 𝑭𝑽 + 𝑩𝑽 𝟐 13 14
• 8. 11/17/2022 Cost of Debt (Example) Dr. Mahmoud Otaify - FMCS: Cost of Capital 15 Suppose we have a bond issue currently outstanding that has 25 years left to maturity. The coupon rate is 9% and coupons. The bond is currently selling for \$908.72 per \$1000 bond. What is the cost of debt? Tax rate = 40%  Coupon = 1000*0.09 = 90  Semiannual coupon = 90/2 = 45  𝒀𝑻𝑴 = 𝟏𝟎𝟎 𝟏𝟎𝟎𝟎 𝟗𝟎𝟖.𝟕𝟐 𝟐𝟓 𝟏𝟎𝟎𝟎 𝟗𝟎𝟖.𝟕𝟐 𝟐 = 10%  Annual pretax cost = 5*2 = 10%  After-tax cost of Debt = RD (1- TC) = 10 x (1 – 0.4 ) = 6% 15 16
• 9. 11/17/2022 Source Amount Weight Cost Equity (E) 600,000 60% 14.2% Preferred (P) 150,000 15% 12% Debt (D) 250,000 25% 10% Capital (V) 1,000,000 Tax Rate 40% WACC WACC= E/V*RE + P/V*RP + D/V*RD(- TC) =0.6*14.2 + 0.15*12 + 0.25*10(1-0.4) = 17 17