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The WACC and Company
? The required rate of return on a firm’s projects
can be calculated using the weighted-average
cost of capital.
? The weighted-average cost of capital (WACC)
is the after-tax return the company needs to earn
in order to satisfy all its security holders.
Company Cost of Capital
? Company Cost of Capital
• The opportunity cost of capital for the firm’s existing
assets. The minimum acceptable rate of return when
the firm expands by investing in average-risk projects.
? Capital Structure
• The mix of long-term debt and equity financing.
Used to value new assets that have the same r isk
as the old ones.
Company Cost of Capital
The company cost of capital is a weighted aver age
of returns demanded by debt and equity investors.
? ?E
rassets = ? × rdebt ? + ? × requity ?
? ?V
Company Cost of Capital:
Macrosoft, Inc. has issued long-term bonds with a present value
of $25 million and a yield of 8%. It currently has 12 million
shares outstanding, trading at $20 each, offering an expected
return of 14%. What is the firm’s cost of capital?
E 12, 000, 000=
× $20 $240 million
Weighted Average Cost of Capital
For proper valuation we must value the firm’s
after -tax cash flows.
Why is it important to account for taxes?
Weighted Average Cost of Capital
The WACC provides a firm’s after-tax cost of
? ?E
WACC = ? × (1- Tc ) × rdebt ? + ? × requity ?
? ?V
Tc = The firm’s average tax rate
Calculating WACC
? A firm’s WACC is calculated in 3 steps:
1. Calculate the value of each security as a proportion
of firm value.
2. Determine the required rate of return on each
3. Calculate a weighted average of the after-tax return
on the debt and return on the equity.
Calculating WACC: Example
What is the WACC for a firm with $30 million in outstanding debt with a
required return of 8%, 8 million in equity shares outstanding trading at $15
each with a required return of 12%, and a tax rate of 35%?
Calculating WACC
If there are 3 (or more) sources of financing, simply
calculate the weighted-average after-tax return of each
security type.
? If the firm issues preferred stock:
? ?P
? ?E
WACC = ? × (1 – Tc )rdebt ? + ? × requity ? + ? × rPreferred ?
? ?V
? ?V
Calculating WACC: Example
Consider a firm with $8 million in outstanding bonds, $15 million
worth of outstanding common stock, and $5 million worth of
outstanding preferred stock. Assume required returns of 8%, 12%, and
10%, respectively, and a 35% tax rate.
In our previous example, we calculated the
firm’s WACC to be 9.7%
? Would NPV be positive or negative if:
• We invested in a project offering a 9% return?
• We invested in a project offering a 10% return?
• We invested in a project offering a 9.7% return?

Measuring Capital Structure
When estimating WACC, use mar ket values,
not book values.
? Market Value of Debt
• Present Value of all coupons and principal, discounted
at the current YTM.
? Market Value of Equity
• Market price per share multiplied by the number of
shares outstanding.
Measuring Capital Structure:
If a firm’s bonds pay a 5% coupon and mature in 3 years, what is
their market value, assuming a 7% yield to maturity? Assume the
bond has a $1,000 par value.
Calculating Expected Returns
To calculate the WACC, we must first calculate the
rates of return that investors expect from each security.
• Expected returns on bonds
• Expected returns on common stock
• Expected returns on preferred stock
Expected Return on Bonds
The risk of bankruptcy aside, the yield to
matur ity represents an investor’s expected
return on a firm’s bonds.
Expected Return on Common
? Estimating requity using CAPM:
Example: A firm’s beta is 1.5, Treasury bills currently yield 4%, and
the long-run market risk premium is 8%. What is the firm’s cost of
Expected Return on Common
? Estimating requity using the DDM:
Example: A firm’s shares are trading for $45 per share. The firm is
expected to pay a $2 per share dividend at the end of the year.
What is its expected return on equity assuming a 9% constant
growth rate?
Expected Return on Preferred
A preferred stock that pays a fixed annual
dividend is no more than a simple perpetuity.
Expected Return on Preferred
Stock: Example
If a share of preferred stock sells for $40 and it pays
a dividend of $3 per share, what is the expected
return on that share of stock?
WACC Pitfalls
The WACC is appropriate only for projects that have
the same r isk as the firm’s existing business.
? Upward/Downward Adjustments
? Altering Capital Structure
• Two costs of debt finance: Explicit and Implicit
Altering Capital Structure:
What is the WACC for a firm with $100 million in debt
requiring a 6% return and $400 million in equity requiring a
10% return? Assume a tax rate of 35%.
What if the firm borrows an additional $150 million to retire
some of its shares, but investors now demand 9% on the debt
and 12% on equity?
Valuing Entire Businesses
We can treat entire companies like giant projects
and value them using the WACC.
Free Cash Flow
Cash flow that is not required for investment in
fixed assets or working capital and is therefore
available to investors.
Valuing Entire Businesses
PVfirm =

(1 + WACC )1 (1 + WACC ) 2
(1 + WACC ) H (1 + WACC ) H
FCF in year ( H + 1)
Horizon Value =
WACC ? g
Valuing Entire Businesses: Example
Use the following information to calculate the value of a
business that your firm is considering acquiring.
Firm’s WACC: 12.5%
Firm’s Cash Flows
• $1 million FCF, years 1-4
• $1.05 million FCF, year 5
• 5% growth after 4 years
Valuing Entire Businesses: Example
PVfirm =
+ … +
(1 + WACC )
(1 + WACC ) (1 + WACC )
(1 + WACC ) H
McGr aw-Hill/Ir win
Copyr ight © 2012 by The McGr aw-Hill Companies, Inc. All r ights r eser ved .
Introduction to Corporate
Firms have three sources of cash from which to
finance their activities.
This chapter provides an overview of debt,
equity, and internally generated funds.
Financial Markets
Competition in financial markets is fierce-much more so than in product markets.
?Few protected niches (ex: cannot patent the
structure of a new security)
?Securities sell for their true values
Corporate Financing
Firms have three broad sources of cash.
? Internally generated funds
? New equity issues
? New debt issues
Internally Generated Funds
Historical sources of funds for FedEx
Why Internal Funds?
Managers prefer to reinvest internal funds for a
number of reasons:
? Cost of issuing securities
? New equity announcement implications
Corporate Financing
What happens when the firm cannot finance all
of its activities from plowed-back funds?
? Financial Deficit
? New Equity Issues
? New Debt Issues
Equity Issues
Most corporations are too large to be owned by one
investor; therefore they issue stock to many
? Example:
Dow is owned by 650,000 different investors. If it has 1.167
billion shares outstanding, how much of Dow does an
investor who holds one share own?
The investor owns:
, or 0.000000085% of Dow
Equity Terminology
? Treasury stock
• Stock that has been repurchased by the company and held in its
? Issued shares and Outstanding Shares
• Shares that have been issued by the company; shares that have
been issued by the company and are held by investors.
? Authorized Share Capital
• The maximum number of shares that the company is permitted to
issue without additional shareholder approval.
Equity Terminology: Example
Imagine a firm has 100 million shares currently trading on
the NYSE. The firm issues 20 million new shares, and
repurchases 5 million shares one month later.
What is the total change in treasury stock?
What is the total change in the number of issued shares?
What is the total change the number of shares outstanding?
Equity Terminology
When a firm issues new equity, it records each
new share in its books at par value.
? Additional Paid-in Capital
• The difference between the issue price and the par
value of a stock
? Retained Earnings
• Earnings not paid out as dividends
Equity Terminology: Example
Suppose a firm has recently issued 10 million new shares at
$15 per share; the par value of each is $1.50.
What is the value of additional paid-in capital (APIC)?
APIC (10, 000, 000 × $15) ? (10, 000, 000 × $1.50)
Net Common Equity
Represents the total amount contributed directly by shareholders
when the firm issued new stock, and contributed indirectly when it
plowed back part of its earnings
Net Common
= Value + Paid-in Capital + Earnings – Repurchases
Net Common Equity: Example
What is the book value per share of equity for a firm with
$1 million in net common equity; 50,000 in authorized
share capital; 25,000 shares issued; and 20,000 shares
Corporate Ownership
A corporation is owned by its common
? Owners are entitled to:
Control of the firm
Corporate Ownership
Shareholders exercise control over the firm by voting for its
board of directors.
• Majority Voting
Voting system in which each director is voted on separately
• Cumulative Voting
Voting system in which all votes that one shareholder is
allowed to cast can be cast for one candidate for the board of
• Proxy Contest
Takeover attempt in which outsiders compete with
management for shareholders’ votes
Corporate Ownership: Example
A shareholder owning 100 shares of stock is voting for the
board of directors who are elected by cumulative voting. How
many votes did the shareholder cast for Director ‘A’ if four
directors are to be elected and the shareholder cast his/her
maximum number of votes for ‘A’?
Preferred Stock
Preferred Stock Advantages:
• Dividends
• Tax Advantages
Potential Disadvantages:
• Interest rate fluctuations
• Floating Rate Preferred
Corporate Debt
When issuing debt, companies promise to make
payments and repay principal. But they have limited
liability; debt is not always repaid.
Debt Characteristics
? Interest rate fluctuations
Coupon vs. Zero-coupon Bonds
? Prime Rate
Would you expect the price of a 10-year floating-rate bond
to be more or less sensitive to changes in interest rates
than the price of a 10-year fixed-rate bond?
Debt Characteristics
? Funded and Unfunded Debt
• Debt with more than 1 year remaining to maturity; debt due
in less than one year.
? Sinking Fund
• A fund established to retire debt before maturity.
? Callable Bond
• A bond that may be repurchased by a firm before maturity
at a specified call price.
If interest rates rise, would holders of callable bonds expect the
firm to buy back the debt?
Debt Characteristics
? Seniority
? Subordinated Debt
? Security
? Secured Debt
? Currency and Country of Origin
? Eurodollars
? Eurobond
Debt Characteristics
? Public vs. Private Placements
? Protective Covenants
• Restrictions on a firm to protect bondholders
? Leases
• Long-term rental agreements
Convertible Securities
Give investor s the option to alter their investments
if they so choose.
? Warrant
• The right to buy shares from a company at a stipulated
price before a set date
? Convertible Bond
• A bond that the holder may exchange for a specified
amount of another security
Convertible Securities: Example
An investor owns a bond selling for $1,000. This bond can
be converted to 20 shares of stock that are currently selling
for $55 per share. Should the investor convert his bond into
Without conversion:
With conversion:
Value of Investment =( 20 × $55 ) =$1,100
McGr aw-Hill/Ir win
Copyr ight © 2012 by The McGr aw-Hill Companies, Inc. All r ights r eser ved .
How Corporations Raise Venture
Capital and Issue Securities
Young firms often require venture capital to
finance growth.
The issuance of securities is a complex process that
the successful financier must comprehend.
Company Growth
Venture Capital provides entrepreneurs with
financing to grow their firms.
Firms issue securities to further finance their
Obtaining Venture Capital
? Steps to obtaining venture funding:
Prepare a business plan.
Receive first-stage financing.
Receive subsequent staged financing.
Venture Capital Ownership:
Suppose a Venture Capital firm offers to purchase 1
million of your firm’s shares for $1 each, which will give
them 50% ownership in the firm. What value are they
placing on your firm?
$1, 000, 000
Value of the Firm =
= $2, 000, 000
Types of Venture Investors
? Angel Investors
• Investors who finance companies in their earliest stages of growth
? Corporate Venturers
• Corporations that offer venture assistance to finance young,
promising companies.
? Private Equity Investing
• Investors who offer funds to finance firms that do not trade on
public stock exchanges such as the NYSE or NASDAQ.
Venture Capital Management
Venture Capitalist are not passive investors.
What do they provide beyond financing?
The Initial Public Offering
When a firm requires more capital than private investors can
provide, it can choose to go public through an Initial Public
Offering, or IPO.
Primary Offering
– when new shares are sold to raise additional cash
for the company
Secondary Offering
– when the company’s founders and venture
capitalists cash in on some of their gains by selling
Does a secondary offering provide additional capital to the firm?
Benefits of Going Public
? Ability to raise new capital
? Stock price provides performance measure
? Information more widely available
Benefits of Going Public
? Diversified sources of finance
? Reduced borrowing costs
Arranging Public Issues
Steps to issue a new public security:
SEC Registration
Prospectus—a formal summary that provides
information on an issue of securities
Select Underwriter / Undertake Roadshow
Set final issue price for public
IPO Flowchart
Underwriter provides advice to firm
Underwriter pays firm for a number of shares
Firm provides shares to underwriter to be resold
Underwriter offers shares to investors
Investors purchase shares from underwriter
Underwriter Spread
Spread – the difference between the public offer
price and the price paid by underwriter
Assume the issuing company incurs $1 million in expenses to sell 3
million shares at $40 each to an underwriter; the underwriter sells
the shares at $43 each. What is the spread for this deal?
Underwriting Arrangements
Firm Commitment:
Underwriters buy the securities from the firm and then
resell them to the public.
Best Efforts Commitment:
Underwriters agree to sell as much of the issue as possible
but do not guarantee the sale of the entire issue.
Underwriting Arrangements:
Capital To Firm
How much will a firm receive in net funding from a firm commitment
underwriting of 250,000 shares priced to the public at $40 if a 10%
underwriting spread has been added to the price paid by the underwriter?
Additionally, the firm pays $600,000 in legal fees.
Underpricing of an IPO
Underpricing: Issuing securities at an offering price set below
the true value of the security.
Example: Assume the issuer incurs $1 million in other expenses to sell 3
million shares at $40 each to an underwriter and the underwriter sells the shares
at $43 each. By the end of the first day’s trading, the issuing company’s stock
price had risen to $70. What is the total cost of underpricing?
Cost of Underpricing:
Flotation Costs
Flotation Costs: The costs incurred when a firm
issues new securities to the public.
What are some of the specific costs incurred when a firm
issues new securities?
Types of Offerings
After the IPO, successful firms may issue additional
equity or debt.
? Seasoned Offering
Rights Issue
Issue of securities offered only to current stockholders.
General Cash Offer
Sale of securities open to all investors by an already-public
Rights Issue: Example
An investor exercises his right to buy one additional share at
$20 for every five shares held. How much should each share be
worth after the rights issue if they previously sold for $50 each?
Pre-Rights Issue:
Post-Rights Issue:
General Cash Offer and
Shelf Registration
Shelf Registration: A procedure that allows firms to file one
registration statement for several issues of the same security.
Benefits of Shelf Registration:
Security issuance without excessive costs
Security issuance on very short notice
Timed issuance to capitalize on favorable market
Additional underwriter competition
Private Placements
In order to avoid registering with the SEC, a
company can issue a security privately.
Private Placement: The sale of securities to a limited
number of investors without a public offering
Private Placements-Advantages
Do not have to register with SEC
Private placements cost less than public issues
Contracts can be customized for each investor
Private PlacementsDisadvantages
Difficult for investors to resell security
Lenders often require higher return to compensate
for higher risk.
• Private placements typically yield .5% higher than
public issues
McGr aw-Hill/Ir win
Copyr ight © 2012 by The McGr aw-Hill Companies, Inc. All r ights r eser ved.
Debt Policy
? Changing a firm’s capital structure should not affect its
value to shareholders.
? This chapter analyzes several possible financing
scenarios and provides an overview of the effects of
taxes and costs of financial distress on a firm.
Does Borrowing Affect Value?
A company’s choice of capital str uctur e does
not increase the value of the firm.
MM’s Irrelevance Proposition
The value of a firm does not depend on its capital
If this holds, can financial managers increase the value
of the firm by changing the mix of securities used to
finance the company?
MM’s Irrelevance Proposition
? Assumptions of MM’s argument:
“Well functioning” capital markets
Efficient capital markets
No taxes (therefore no distortion)
Ignore costs of financial distress
MM’s Irrelevance Proposition
Example: An all-equity financed firm has 1 million shares outstanding, currently
selling at $10 per share. It considers a restructuring that would issue $4 million in
debt to repurchase 400,000 shares. How does this affect overall firm value?
Before Restructuring:
After Restructuring:
How Borrowing Affects EPS
Ceteris paribus, borrowing will increase earnings per share.
However, this isn’t a source of value to shareholders.
?Shareholders can easily replicate a firm’s
borrowing on their own if they choose.
How Borrowing Affects Risk and
? Debt financing does not affect the operating
risk of the firm.
? Debt financing does affect the financial risk
of the firm.
How Borrowing Affects Risk and
Debt and the Cost of Equity
Debt and the Cost of Equity:
What is the expected return on equity for a firm with a 14%
expected return on assets that pays 9% on its debt, which
totals 30% of assets?
MM’s Proposition II
Debt increases financial risk and causes
shareholders to demand higher rates of return.
Debt and Taxes
Debt financing advantage: the interest that a firm pays
on debt is tax deductible.
Interest tax shield:
Perpetual Tax Shield
If the tax shield is perpetual, then:
Perpetual Tax Shield: Example
What is the present value of the tax shields for a firm that
anticipates a perpetual debt level of $12 million at an interest
rate of 4% and a tax rate of 35%?
Tax Shield and Shareholders’
When accounting for taxes, borrowing increases firm
value and shareholders’ wealth.
Taxes and WACC
Recall that the WACC takes into account the required after-tax
rate of return
Taxes and WACC: Example
What is the expected rate of return to shareholders if the firm
has a 35% tax rate, a 10% rate of interest paid on debt, a 15%
WACC, and a 60% debt-asset ratio?
Costs of Financial Distress
Investors factor the potential for future distress into their
assessment of current value.
Overall Market
PV costs of
Value if all + PV tax –
financial distress
equity financed
Bankruptcy Costs
If there is a possibility of bankruptcy, the current market value
of the firm is reduced by the present value of all court expenses.
Financial Distress Without
Even if a firm narrowly escapes bankruptcy, this does not
mean that costs of financial distress are avoided.
? Stockholders may be tempted to play games at the
expense of creditors
Betting the Bank’s Money
Not Betting Your Own Money
Loan Covenant: Agreement between a firm and lender requiring
the firm to fulfill certain conditions to safeguard the loan.
Explaining Financing Choices
? The Trade-off Theory
• Debt levels are chosen to balance interest tax shields
against the costs of financial distress.
? A Pecking Order Theory:
• Firms prefer to issue debt rather than equity if internal
finance is insufficient.
Financial Slack
Financial Slack: Ready access to cash or debt financing.
Financial managers usually place a very high
value on having financial slack.
Two Faces of Financial Slack
? Benefits
• Long run value rests more on capital investment and
operating decisions than on financing.
• Most valuable to firms with positive-NPV growth
? Drawbacks
• Too much financial slack may lead to lazy management.
• Managers may try to increase their own perks or engage
in empire-building.
McGr aw-Hill/Ir win
Copyr ight © 2012 by The McGr aw-Hill Companies, Inc. All r ights r eser ved.
Payout Policy
Firms can pay cash to shareholders in two major ways;
cash dividends and share repurchases.
This chapter analyzes both options and provides the
student with insight into a firm’s payout policy
How Corporations Pay Cash to
Corporations can pay shareholders by paying a
dividend or by r epur chasing shar es.
Dividends and stock repurchases,
United States 1980-2008
Paying Dividends
Cash Dividend-Payment of cash by the firm to its
Regular Dividend
? Special Dividend
Stock Dividend/Split
Distributions of additional shares to a firm’s
Stock Dividends: Example
Imagine a corporation currently has 10 million shares
outstanding selling at $60 per share and declares a three-for-two
stock split.
After the split, how many shares will be outstanding?
After the split, what will be the new share price?
Dividend Policy: Key Dates
Union Pacific Quarterly Dividend Key Dates
What would you expect to happen to the price of a share
of stock on the day it goes ex-dividend?
The price should decrease by the amount of the dividend.
Dividends: Example
Imagine a firm has 100,000 shares outstanding, worth $1 million in total. If the
firm issues a $1-per-share cash dividend, how is shareholder wealth affected?
Before Dividend:
After Dividend:
After the cash dividend, the market value of the firm falls to
$900,000 and shareholders gain $100,000 in cash.
Stock Repurchases
Stock Repurchase – When a firm buys back stock from its
Four ways to implement:
Open-market repurchase
Tender offer
Direct negotiation
Stock Repurchase: Example
Imagine a firm has 100,000 shares outstanding, worth $1 million in total. If the
firm buys back 10,000 shares at $10 each, how is shareholder wealth affected?
Before Dividend:
After Repurchase:
After the cash dividend, the market value of the firm falls to
$900,000 yet shareholders retain equal ownership in the firm.
Stock Repurchase: Example
After the repurchase, shareholders can sell 10% of their shares
and earn $100,000 in cash, yet still retain ownership equal to
that which they had before.
The shareholders’ position is exactly the same with the share
repurchase as with the cash dividend:
• Total shares worth $900,000
• Cash worth $100,000
Share Valuation
In chapter 7, the dividend discount model taught us that the
price of a share is the PV of future cash flows per share.
What if the dividend is a repurchase, not a cash
Consider the following two examples.
Share Valuation: Example 1
Case 1: A firm promises to pay dividends of $100,000 in perpetuity
with 100,000 shares outstanding. Assume a discount rate of 11.1%. What
is the present value of one of the firm’s shares?
Share Valuation: Example 2
Case 2: This same firm decides instead to use the first year’s proposed
dividends of $100,000 to repurchase 10,000 shares of stock. From year 2
onward it will resume annual dividends of $100,000. What effect does this
have on the value of the shares?
Dividend Policy
Survey of Financial Executives: Views on Dividend Policy
Dividends are surprisingly “smooth” annually, and managers are often
reluctant to alter them.
Information Signaling
Dividends and repurchases provide clues about a
company’s true financial prospects.
Informational aspect of dividends
• Dividend increases send good news about future cash
flow and earnings. Dividend cuts send bad news.
If management announces an unexpected cut in dividend payments, what do
you predict will happen to share price for the firm?
The Payout Controversy
What is the effect of a change in dividend payout
policy, given a firm’s current capital budgeting and
borrowing decisions?
Are Dividends Irrelevant?
Franco Modigliani and Merton Miller (MM) showed that dividend
policy does not alter firm value under the assumption of perfect
financial markets.
MM’s Dividend-Irrelevance Proposition
Under ideal conditions, the value of the firm is
unaffected by dividend policy.
Dividend Policy Irrelevance:
Case 1: A firm plans to pay annual dividends of $5 per share in perpetuity, and
shareholders expect an 8% rate of return. Assume 1,000,000 shares outstanding.
What are the total dividends paid each period, and what is the present value of
each share?
Dividend Policy Irrelevance:
Example 2
Case 2: In an attempt to increase share value, this same firm plans to instead
pay annual dividends of $10 per share in perpetuity, and still shareholders
expect an 8% rate of return. Assume 1,000,000 shares outstanding. What is
the present value of each share?
(continued on next slide)
*Note: In order to pay the additional $5,000,000 in dividends and earn the
same profits in the future, the firm must replace the lost cash with a new
issue of shares.
Dividend Policy Irrelevance:
Example 2
Case 2 (Continued):
*Note: The firm must now pay an additional $400,000 per year in dividends
to the new shareholders:
As long as the company replaces the extra cash it’s paying out, it will earn
the same profits and pay our $5,000,000 of dividends each year from year 2.
$400,000 of this will be used to satisfy new shareholders.
Dividend-Irrelevance Assumptions
In order for MM’s Dividend-Ir r elevance
Pr oposition to hold, we must assume an
efficient capital market.
Why Dividends May Increase Value
Once we relax the assumptions of perfect and efficient capital markets, many
investors claim dividends may actually incr ease value.
? Attracts natural clientele
? Leverages behavioral psychology
? Prevents managers from wasting funds
Why Dividends May Reduce Value
If dividends are taxed more heavily than capital gains, a company that can
convert dividends into capital gains should attract more investors.
All other things being equal, investors are willing to pay
more for a stock whose returns come in the form of lowtaxed capital gains.
In recent years, the case for low dividends has
been weakened.
Top tax rates on dividends: 15%
? Top tax rates on capital gains: 15%
? One advantage to investors:
Capital gains taxes are deferrable.
? One advantage to corporations:
Corporations pay corporate income tax on only 30% of
any dividends received from investments in other
McGr aw-Hill/Ir win
Copyr ight © 2012 by The McGr aw-Hill Companies, Inc. All r ights r eser ved.
Long-Term Financial Planning
Financial plans establish a firm’s financial goals
and provide a benchmark for evaluating
This chapter analyzes long-term financial plans
and provides a discussion of growth.
Financial Planning
Firms plan for both the short term and the long
? Planning Horizon
• Short-term planning: Plans for the next 12 months.
• Long-term planning: Plans that exceed t

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