Weighted Average Cost of Capital
without taxes
WACC = rdebt (D) + requity (E)
(V) (V)
Weighted Average Cost of Capital without taxes & bankruptcy risk
r
D
V
rD
rE
Weighted Average Cost of Capital without taxes & bankruptcy risk
r
D
V
rD
rE
WACC
Weighted Average Cost of Capital without taxes
r
D
V
rD
rE
Includes Bankruptcy Risk
Weighted Average Cost of Capital without taxes
r
D
V
rD
rE
Includes Bankruptcy Risk
Weighted Average Cost of Capital without taxes
r
D
V
rD
rE
Includes Bankruptcy Risk
WACC
Weighted Average Cost of Capital without taxes
r
D
V
Includes Bankruptcy Risk
WACC
r*
D*
Factors in CS & CB Decision
Bankruptcy Risk & Costs (previous slides)
Signaling Hypothesis
Bondholder Wealth Expropriation Theory
Agency Costs
The Principal Agent Problem
Shareholders = Owners
Managers = Employees
Question: Who has the power?
Answer: Managers
Agent Problems
Reduced effort
Perks
Empire building
Entrenching investment
Avoiding risk
Agency Problems in Capital Budgeting
Agency Incentive Issues
Monitoring - Reviewing the actions of managers and providing incentives to maximize shareholder value.
Free Rider Problem - When owners rely on the efforts of others to monitor the company.
Compensation - How to pay managers so as to reduce the cost and need for monitoring and to maximize shareholder value.
Factors in CS & CB Decision
continued
Cash Flow estimates & Market Values
Projects may appear to have positive NPVs because of forecasting errors
. some acquisitions result from errors in a DCF analysis
Don’t make investment decisions on the basis of errors in your DCF analysis.
Start with the market price of the asset and ask whether it is worth more to you than to others.
Measuring performance
MVA
EVA & Residual income
Economic Income
CFROI
Factors in CS & CB Decision
continued
MVA
Market Value Added
MVA = Market Cap year 2 – Market cap year 1
Residual Income & EVA
Techniques for overcoming errors in accounting measurements of performance.
Emphasizes NPV concepts in performance evaluation over accounting standards.
Looks more to long term than short term decisions.
More closely tracks shareholder value than accounting measurements.
EVA by Stern and Stewart out of Boston
Residual Income & EVA
Income
Sales 550
COGS 275
Selling, G&A 75
200
taxes @ 35% 70
Net Income $130
Assets
Net . 80
Property, plant and equipment 1170
less depr. 360
Net Invest.. 810
Other assets 110
Total Assets $1,000
Quayle City Subduction Plant ($mil)
Residual Income & EVA
Quayle City Subduction Plant ($mil)
Given COC = 10%
Residual Income & EVA
Residual Income or EVA = Net Dollar return after deducting the cost of capital
EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
Residual Income & EVA
Quayle City Subduction Plant ($mil)
Given COC = 12%
Economic Profit
Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital.
EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
Economic Profit
EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
Quayle City Subduction Plant ($mil)
Example at 12% COC continued.
Message of EVA
+ Managers are motivated to only invest in projects that earn more than they cost.
+ EVA makes cost of capital visible to managers.
+ Leads to a reduction in assets employed.
- EVA does not measure present value
- Rewards quick paybacks and ignores time value of money
EVA of US firms - 1997
$ in millions)
CFROI
(Building a better mouse trap)
Developed by Holt Value Associates, Inc. in Chicago
Modified NPV approach
Basically a “decomposed” DCF model
Utilizes objective data inputs
CFROI
(Building a better mouse trap)
NCRs = Net Cash Receipts (from operations)
are derived from sources and uses of funds statements
Are calculated in 2 parts (existing operations & future investments)
Discount Rates
Implied from market, using valuation models
Adjusted for Capital structure
Non-operating Assets = Land & others
CFROI
(Building a better mouse trap)
Problem 1
Our company has the opportunity to invest in a project. Our initial outlay is $500. The project will yield $1200 at the end of the fourth year. Given a company cost of capital of 14%, what is the NPV of the project?
Problem 1
Our company has the opportunity to invest in a project. Our initial outlay is $500. The project will yield $1200 at the end of the fourth year. Given a company cost of capital of 14%, what is the NPV of the project?
Answer
NPV = -500 + 1200 / (1+.14)4 =
Problem 2
You are going to retire next month. An insurance agent offers to sell you an annuity which pays $20,000 per year (at the start of each year) for 15 years. Assuming a yield of 8% on the annuity, how much should you pay for the annuity?
Problem 2
You are going to retire next month. An insurance agent offers to sell you an annuity which pays $20,000 per year (at the start of each year) for 15 years. Assuming a yield of 8% on the annuity, how much should you pay for the annuity?
Answer PV = C [ ] + first yr
PV = 20k + 20k[ ] = 184,884
1 1
r r(1+r)t
_
1 1
.08 .08(1+.08)14
_
Problem 3
If you sign an agreement today (t=0) to borrow $400 at the end of year 1, $400 at the end of year two, and repay $1000 at the end of year three, what is the interest rate you are paying? (hint: calculate the IRR)
Problem 3
If you sign an agreement today (t=0) to borrow $400 at the end of year 1, $400 at the end of year two, and repay $1000 at the end of year three, what is the interest rate you are paying? (hint: calculate the IRR)
Answer
T0 T1 T2 T3
0 + 400 + 400 - 1000
calculator return %
Problem 4
If you attempt to diversify your portfolio using BGE & Disney stock, which Portfolio, A, B, C is possible?
Risk
Return
DIS
BGE
A
B
C
Problem 4
If you attempt to diversify your portfolio using BGE & Disney stock, which Portfolio, A, B, C is possible?
Risk
Return
DIS
BGE
A
B
C
Problem 5
Based on the success of EuroDisney, Disney wishes to build two additional theme parks (SlavicDisney in Moscow, Russia and AfricaDisney in Lagos, Nigeria). Disney has a cost of capital of 14%. The company is in three industries; Movies,Theme Parks, & Consumer Products, with betas of , , and , respectively. Tbills are yielding 7% and the market return is at 15%.
What discount rate SHOULD the company use when evaluating these projects?
Problem 5
Based on the success of EuroDisney, Disney wishes to build two additional theme parks (SlavicDisney in Moscow, Russia and AfricaDisney in Lagos, Nigeria). Disney has a cost of capital of 14%. The company is in three industries; Movies,Theme Parks, & Consumer Products, with betas of , , and , respectively. Tbills are yielding 7% and the market return is at 15%.
What discount rate SHOULD the company use when evaluating these projects?
r = .07 + ( .15 - .07 ) = %
Problem 6
Based on the success of EuroDisney, Disney wishes to build two additional theme parks (SlavicDisney in Moscow, Russia and AfricaDisney in Lagos, Nigeria). Disney has a cost of capital of 14%. The company is in three industries; Movies,Theme Parks, & Consumer Products, with betas of , , and , respectively. Tbills are yielding 7% and the market return is at 15%.
What discount rate should Disney use if it wishes to modernize its consumer products production facility & why?
Problem 6
Based on the success of EuroDisney, Disney wishes to build two additional theme parks (SlavicDisney in Moscow, Russia and AfricaDisney in Lagos, Nigeria). Disney has a cost of capital of 14%. The company is in three industries; Movies,Theme Parks, & Consumer Products, with betas of , , and , respectively. Tbills are yielding 7% and the market return is at 15%.
What discount rate should Disney use if it wishes to modernize its consumer products production facility & why?
14% because that is its borrowing rate.
Problem 7
DogDays Toy Co common stock is providing a 16% return. The company has no debt, but has a bond rating of AA (ytm=9%). Analysts feel that DogDays could add up to 30% debt without altering the required return on debt or equity. The company would like to build a plant to produce doggy basketball equipment, but the IRR is only 14% (where NPV = 0). What action can DogDays take to make the basketball project feasible?
Problem 7
DogDays Toy Co common stock is providing a 16% return. The company has no debt, but has a bond rating of AA (ytm=9%). Analysts feel that DogDays could add up to 30% debt without altering the required return on debt or equity. The company would like to build a plant to produce doggy basketball equipment, but the IRR is only 14% (where NPV = 0). What action can DogDays take to make the basketball project feasible?
Answer
Take on 30% debt and decrease the company’s COC.
r = 9 (30/100) + 16 (70/100) = %
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