Week 05 Risk Management

COST OF CAPITAL (PART 2)
OF COMMON EQUITY AND WACC

STPECNOC NIAM
COST OF COMMON EQUITY
#1-2) YTM+RISK PREMIUM
AND CAPM
#3) DCF APPROACH
WEIGHTED AVERAGE COST
OF CAPITAL
KEY INFO
OVERVIEW OF PREVIOUS COMPUTATIONS OF THE
COST OF COMMON EQUITY (Re)
YTM + RISK PREMIUM CAPM DISCOUNTED CASH

APPROACH SML/CAPM: FLOW (DCF)
Re = YTM + RISK PREMIUM Re = Rf + [E(Rm) - Rf] (DIVIDEND
DISCOUNT MODEL)
DDM/ DIVIDEND DISCOUNT MODEL/
DISCOUNT CASH FLOW
DCF METHOD
A quantitative method of valuing a company’s
stock price based on the assumption that the
current fair price of a stock equals the sum of
all of the company’s future dividends
discounted back to their present value.
It only applies to companies that pay dividends,
and it also assumes that the dividends will
grow at a constant rate.
The model does not account for investment
risk to the extent that CAPM does (since
CAPM requires beta).
The Gordon Growth Model (GGM) is one
of the most commonly used variations of
the dividend discount model. The model is
called after American economist Myron J.
LEDOM HTWORG NODROG

Gordon, who proposed the variation.
Based on the assumption that the stream
of future dividends will grow at some
constant rate in the future for an infinite
time.
Helpful in assessing the value of stable
businesses with strong cash flow and
steady levels of dividend growth.
Generally assumes that the company being
MGG
evaluated possesses a constant and stable
business model and that the growth of the
company occurs at a constant rate over
time.
PART A: COST OF
RETAINED EARNINGS
EXAMPLE 01:
A firm's stock is currently selling for $23 per share. Cost of INTERNAL EQUITY.
Dividend already paid (i.e. D0) is $2 per share. Earnings Because stockholders should get a
are expected to grow at an annual rate of 7%. What is return on reinvested money, the
the cost of retained earnings? company needs to pay the
stockholders for using the retained
earnings.
There's no sale of the equity, so
there's no flotation costs involved. It's
simply reinvesting the dividends that
should have been paid to equity
holders.
PART B: COST OF NEW
ORDINARY SHARES
EXAMPLE 02: Cost of EXTERNAL EQUITY.
What if the flotation cost of selling the new common This is the required rate of return of
stock is 12%? What is the cost of the new ordinary the common stockholders.
shares? Since unlike retained earnings, these
are sold, it involves flotation costs.
If not for the flotation costs, its value
will be the same as the cost of
retained earnings!
Alternative Formula:
THE WACC
THE WEIGHTED AVERAGE COST OF CAPITAL
WACC
THe weighted cost of debt and
equity used to finance a firm's
projects.
IT SHOWS THE AVERAGE RATE
OF RETURN REQUIRED (NEEDED)
BY THE FIRM'S INVESTORS
(BONDHOLDERS AND
STOCKHOLDERS)
WACC
If the PREFERRED STOCK is part of
the company's CAPITAL STRUCTURE,
we will include it in the formula!
WACC
Let's say Firm BSBA has the
following capital structure:
with the following financing

costs:
What is its weighted

average cost of capital?
WHAT IF...!
THE WEIGHTS ARE NOT GIVEN?
LOOK AT THE CAPITAL STRUCTURE OF

THE FIRM!!!
CAPITAL STRUCTURE
The mix of debt and equity capital
invested in the firm.
Summarized by the firm's Debt Ratio
(Wd) and Equity Ratio (We).
Can be estimated using book values
(balance sheet values - HISTORICAL) and
market values (current value in the market
- PRESENT VALUE)
BOOK VALUE
CAPITAL
STRUCTURE
Uses historical data from the
balance sheet
Includes RETAINED EARNINGS
Short-term loans are included
ONLY IF THEY'RE RECURRING
DEBT. If you don't include it,
you're ignoring the interest-
bearing debt!
MARKET VALUE
CAPITAL
STRUCTURE
Uses PRESENT VALUES of
debt and equity
Better to use than Book Value
Capital Structure since it's more
accurate, current, and realistic
Puts more emphasis on
interest-bearing debt and
equity. Retained earnings is
usually excluded.
FIND PRESENT VALUE (PV) OF THE BOND!
NOTE:
RECURRING SHORT-TERM LOANS RARELY HAVE
CHANGES IN INTEREST SINCE THEY ARE USUALLY
PAID WITHIN 12 MONTHS (AT MOST). SO WE JUST
COPY THE FIGURE FROM THE BALANCE SHEET!
WACC COMPUTATION
NOTE: The WACC is used as a HURDLE RATE to assess whether or not a company
produces value for investors measured by the return on investment of capital (ROIC).
If a company's WACC is greater than it's ROIC then the company is generating a
net negative return on capital and vice versa!
THE VALUATION FCF = Free Cash Flow
The goal of the firm is to MAXIMIZE N = Investment Period
SHAREHOLDER WEALTH BY r = Required Rate of Return
MAXIMIZING THE VALUE OF THE
(WACC)
FIRM!
The firm's PV is infinite

since it will continuously
apply itself into projects
The project's PV is N since
it has an economic life
EXAMPLE:
PROJECT VALUATION Let's say you're given a project's
expected cash flows.
The WACC (Required Return) is
R = 12%
Year Cash Flows
1 4,000
2 1,000
3 800
4 600
If investing on this project will cost you less than 5,489.59, go for it,
because your NPV will be positive. 5 300
If investing on this project will cost you more than 5,489.59, DO NOT
get it because your NPV will be negative.
CORPORATE VALUATION
The HORIZON VALUE is the projected cash flow

of the firm beyond the given year. We will use
the Constant Growth Model for this!
CORPORATE VALUATION EXAMPLE:
Let's say you're given a firm's projected free
cash flows. If the WACC (Required Return) is
12% and the Earnings Growth Rate After the
Horizon is 4%, what is the PV of the firm?
Year Cash Flows
1 5,000
2 6,800
3 7,000
If the company's debt is more than its PV (Intrinsic value), it's going to
4 8,500
be in trouble.
5 9,000
EQUITY VALUATION If the firm has $60,000 outstanding
debts, calculate the intrinsic value of
the its equity. How much will be the
present value of the firm's stock price?
ENDE

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COST OF CAPITAL (PART 2)

OF COMMON EQUITY AND WACC

YTM + RISK PREMIUM CAPM DISCOUNTED CASH

LEDOM HTWORG NODROG

with the following financing

What is its weighted

LOOK AT THE CAPITAL STRUCTURE OF

The firm's PV is infinite

The HORIZON VALUE is the projected cash flow

Year Cash Flows

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