B3-FINANCIAL MANAGEMENT-WACC Flashcards
Financial Managment
The Weighted Average Cost of Capital and Optimal Capital Structure
WACC
What is it?
WACC serves as a major link between the long-term investment decisions associated with a corporations capital structure and the wealth of a corporation’s owners. It is the average cost of all forms of financing used by the company. Often used internally as a hurdle rate for capital investment decisions. Optimal structure is mix of financial instruments that produces the lowest WACC.
Financial Managment
The Weighted Average Cost of Capital and Optimal Capital Structure
WACC
Value of firm
The value of a firm can be computed as the present value of the CF it produces, discounted by the costs of capital used to finance it. The mixture of debt and equity financing that produces the lowest WACC maximizes the value of the firm.
Financial Managment
The Weighted Average Cost of Capital and Optimal Capital Structure
WACC
Formula
Cost of equity multiplied by the percentage equity in capital structure + Weighted average cost of debt (after tax) multiplied by the percentage debt in capital structure
Financial Managment
The Weighted Average Cost of Capital and Optimal Capital Structure
Cost of Capital Components
Debt Characteristics
Debt carries the lowest cost of capital and is tax deductible.
The higher the tax rate, the more incentive exists to use debt financing-“Tax benefits are high if taxes increase and the company is profitable.
Financial Managment
The Weighted Average Cost of Capital and Optimal Capital Structure
Cost of Capital Components
Cost of Preferred Stock Formula and Characteristcs
= Preferred Stock Dividends / Net proceeds of preferred stock = Par times % / Net Inflow
Characteristics
The cost of preferred stock is greater than the cost of debt
Preferred stockholders assume more risk
Financial Managment
The Weighted Average Cost of Capital and Optimal Capital Structure
Cost of Capital Components
Net Proceeds of Preferred Stock example
The net proceeds from a preferred stock issuance can be calculated as the gross proceeds net of flotation costs.
Facts
Assume that the pref stock component of the WACC for a firm is 10%, $100 par value prf stock that was issued at par value with a flotation cost of $5 per share. Compute the cost of preferred stock.
Solution
Prf stock dividend= dividend percentage times par value = 10% x $100 = $10
Cost of Prf Stock = Dividend / Net Proceeds
= $10 / ($100-$5)
=$10 / $95
=.10526
Financial Managment
The Weighted Average Cost of Capital and Optimal Capital Structure
Cost of Capital Components
Cost of Retained Earnings
Cost of equity capital obtained through retained earnings is equal to the rate of return required by the firm’s common stockhodlers. A firm should earn at least as much on any earnings retained and reinvensted in the business as stockholders could have earned on alternative investments of equivalent risk.
Financial Managment
The Weighted Average Cost of Capital and Optimal Capital Structure
Cost of Capital Components
Cost of Retained Earnings
Three common methods of computing the cost of retained earnings
- Capital Asset Pricing Model (CAPM)
- Discounted Cash Flow (DCF)
- Bond yield plus risk premium (BYRP)
Financial Managment
The Weighted Average Cost of Capital and Optimal Capital Structure
Cost of Capital Components
Cost of Retained Earnings
CAPM Key Assumptions and formula
- `Cost of retained earnings equal to the risk-free rate plus a risk premium
- Risk Premium is equal to the systematic (nondiversifiable) risks associated with the overall stock market.
- The beta coefficient is a numerical representation of the volatility (risk) of the stock relative to the volatility of the overall market. Beta of 1=stock is as volatile as market and a beta greater (less) than 1 means the stock is more (less) volatile than the market.
- The risk premium is the stock’s beta coefficient multiplied by the market risk premium.
- The market risk premium is the market rate of return minus the risk-free rate
Formula
=Risk-free rate+ risk premium
=Risk-free rate+ (Beta x Market Risk Premium)
=Risk Free Rate + [Beta x (Market Return-Risk-free rate)]
Financial Managment
The Weighted Average Cost of Capital and Optimal Capital Structure
Cost of Capital Components
Cost of Retained Earnings
Discounted Cash Flow (DCF) Formula
Cost of retained earnings= (D1 / P0) + g
P0 = Current Market Value or price of the outstanding common stock
D1 = The dividend per share expected at the end of the year
g= The constant rate of growth in dividends
“Dividend Yield + Growth”
Financial Managment
The Weighted Average Cost of Capital and Optimal Capital Structure
Cost of Capital Components
Cost of Retained Earnings
The Bond Yield Plus Risk Premium Formula
Cost of retained earnings= Pretax cost of long-term debt + Market Risk premium
