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Corporate Finance

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Corporate Finance ­FIN 622
VU
Lesson 19
COST OF DEBT & WEIGHTED AVERAGE COST OF CAPITAL (WACC)
The following topics will be discussed in this lecture.
Venture Capital
Cost of Debt & Bond
Weighted average cost of debt
Tax and cost of debt
Cost of Loans & Leases
Overall cost of capital ­ WACC
WACC & Capital Budgeting
Venture Capital
Venture capital is capital typically provided by outside investors for financing of new, growing or struggling
businesses. Venture capital investments generally are high risk investments but offer the potential for above
average returns. A venture capitalist (VC) is a person who makes such investments. A venture capital fund is
a pooled investment vehicle (often a partnership) that primarily invests the financial capital of third-party
investors in enterprises that are too risky for the standard capital markets or bank loans.
Alternatives to Venture Capital
Because of the strict requirements venture capitalists have for potential investments, many entrepreneurs
seek initial funding from angel investors, who may be more willing to invest in highly speculative
opportunities, or may have a prior relationship with the entrepreneur.
Furthermore, many venture capital firms will only seriously evaluate an investment in a start-up otherwise
unknown to them if the company can prove at least some of its claims about the technology and/or market
potential for its product or services. To achieve this, or even just to avoid the dilutive effects of receiving
funding before such claims are proven, many start-ups seek to self-finance until they reach a point where
they can credibly approach outside capital providers such as VCs or angels. This practice is called
"bootstrapping".
In industries where assets can be scrutinized effectively because they reliably generate future revenue
streams or have a good potential for resale in case of foreclosure, businesses may more cheaply be able to
raise debt to finance their growth. Good examples would include asset-intensive extractive industries such
as mining, or manufacturing industries. The following factors should be considered before making decision
to raise capital through venture:
­
limited market and access of VC
­
introduction market ­ it works on personal contacts
­
very expensive option
­
Stake in management make it risky for original owners.
­
No physical collateral is required.
­
Venture capitalist must be financially strong.
­
previous track record or success rate
­
Style of venture capitalist ­ in addition to money skill set will  definitely add value.
­
Contacts of VC are very important.
­
Exit strategy must be finalized.
Cost of Debt ­ Bonds
A company may have several bond issues outstanding. From debt family we need to calculate first the cost
of each class of debt and then we will calculate the cost of debt by taking into account cost of each
component using their weight age from total debt. Consider the following example:
Weighted Average
Bond
Book
% of
MV of
% of
YTM
BV
MV
ISSUE
Value
BV
Bonds
MV
500.00
0.33
501.50
0.35
6.24
2.09
2.18
D
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Corporate Finance ­FIN 622
VU
496.00
0.33
440.50
0.31
8.36
2.78
2.56
F
200.00
0.13
206.90
0.14
7.31
0.98
1.05
R
297.00
0.20
287.40
0.20
7.90
1.57
1.58
T
1,493.00
1,436.30
7.42
7.37
A company has four outstanding bond issues having different yield to maturity and market value. We have
both book values and market values in the above table but using market values are preferred for computing
weighted average of cost of bond interest because the market value reflect the current risk level in prices,
Total BV of bond debt is 1493 million and third column from left hosts the % portion of each issue from
the total bond debt. In fourth and 5th columns we have market values of bonds and weight of each issue
from total market value.
In the last two columns we have cost of each issue by multiplying YTM with BV and MV. The weighted
average cost of bond debt is 7.37% using market values.
Like the way we calculated the bond single rate as cost of debt, the cost of loan with a difference that
normally we take the book values of debt in computing the single loan rate.
It will be pertinent to note here that the interest paid on loans, bonds and leases are tax deductible whereas
the dividend paid to preference shareholders is NOT tax deductible. When we are calculating the single cost
rate of debt family we must take into account the tax deductibility of loans, bonds and leases.
After-tax Cost of Debt
After-tax cost of debt = Interest rate x (1 - tax rate)
EXAMPLE:
0.08 = 10% x (1 - 0.2)
This explains how we work out the after tax cost of debt.
Weighted Average Cost of Capital
Once we have calculated the individual component cost then we move ahead to compute the overall
weighted average cost of capital. The process is to find the weight of each component from overall
capitalization and then multiply it by the interest cost of each component. Adding all the resulting
numbers give us the WACC.
A calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All
capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a
WACC calculation.
WACC is calculated by multiplying the cost of each capital component by its proportional weight and then
summing:
Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
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Corporate Finance ­FIN 622
VU
D/V = percentage of financing that is debt
Tc = corporate tax rate
Broadly speaking, a company's assets are financed by either debt or equity. WACC is the average of the
costs of these sources of financing, each of which is weighted by its respective use in the given situation. By
taking a weighted average, we can see how much interest the company has to pay for every dollar it
finances.
A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally
by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is
the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm.
Capital Budgeting
A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally
by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is
the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm.
Popular methods of capital budgeting include net present value (NPV), internal rate of return (IRR),
discounted cash flow (DCF) and discounted payback period. The discount rate used to find out the PV of
future cash flow is normally the WACC.
In capital budgeting context it should be remember that WACC will only be appropriate discount rate if the
proposed project has the same risk level. If the risk levels of proposed and existing projects are different
then it would be misleading to use WACC as discount rate.
Consider the following example that will aid in understanding the use of WACC in capital budgeting
decisions.
·
Example: a company intends to undertake a project that will yield after tax saving of Rs. 4 million at
the end of year one. However, after that these savings are estimated to grow at 6 percent. The debt
equity ratio of 0.5. Cost of equity is 25% and cost of debt is 11%. This project has the same level of
risk as the existing company business. Advise company on the financial viability of project. Assume
tax rate of 40 percent.
·  WACC = 2/3*25 + 1/3 * 11(1-40) = 18.86
·  PV = benefit / WACC - g
·  PV = 4,000,000 / .1886 ­ 0.06 = 31,104,199/-
Since the NPV is positive the project can be undertake.
65
Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk