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12 The Cost of Capital 12-1 Geothermals Cost of Capital Geothermals market value balance sheet Market Value Balance Sheet Assets (V) $647 | Debt (D) $194 (30%) | Equity (E) 453 (70%) $647 $647 Geothermal is a business. => value of business = value of the portfolio of all firms debt and equity securities risk of business = risk of the portfolio invetors required rate of return on business = investors required rate of return on the portfolio = the company cost of capital Example: rD = 8%, rE = 14% => the portfolio return = 0.38% + 0.714% = 12.2% => rA (the company cost of capital) = 12.2% 12-2 The Weighted-Average Cost of Capital estimating company cost of capital as a weighted average The company cost of capital (rA) is the weighted average of the returns demanded by debt and equity investors: D E rA = ( rD ) + ( rE ) V V The return is also called the weighted-average cost of capital (the WACC ). Notes: 1) Recall the definition of the company cost of capital: the opportunity cost of capital for the firms existing assets. 2) The WACC is a way of estimating the company cost of capital.
taxes

and the WACC

Interest payments on debt securities are deducted from income before tax is calculated. A simple Income Statement:
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Sales - Costs of Goods Sold Operating Income - Interest Expense Taxable Income

$100 -70 $30 -10 $20

the after-tax cost of debt (the after-tax rD ):

Geothermals cost of debt (rD) = 8% With a corporate tax rate (TC ) of 0.35, the income tax that the firm pays is reduced by 35% of its interest expense (i.e., reduced by 35%$30 = $10.5). => the after-tax cost of debt = pretax cost of debt (1 corporate tax rate) = rD (1 - TC) = 8% (1 0.35) = 5.2% D E => the WACC (rA) = [ (1 TC ) rD ] + ( rE ) V V = [0.3(1 0.35) 8%] + (0.714%) = 11.36% 11.4%
more

sources of financing D P E the WACC (rA) = [ (1 TC ) rD ] + ( rP ) + ( rE ) V V V , where V = D + P + E, P = preferred stock () estimating Executive Fruits WACC rD = 6% rP = 12% rE = 18%

example:

the value of debt (D) = $4 million the value of preferred stock (P) = $2 million the value of common stock (E) = $6 million the corporate tax rate (TC) = 35% What is the Executive Fruits WACC?

We find that: V = $12 million, and D/V = 0.33, P/V = 0.17, and E/V = 0.5. The WACC is given by [0.33(1-0.35)6%] + (0.1712%) + (0.518%) = 12.3%.
example:

evaluating Geothermals proposed expansion at its WACC (rA):

The proposed expansion costs $30 million and generates a perpetual cash flow of
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$3.42 million per year. A simple cash-flow worksheet might look like this: Revenue - Operating Expenses Pretax Operating Cash Flow - Tax at 35% After-tax Cash Flow $8.34 million - 3.08 $5.26 - 1.84 $3.42 million

With an investment of $30 million (C0 = $30 million), the internal rate of return (IRR) on this perpetuity ( ) is exactly 11.4%: rate of return = 3.42/30 = 11.4% a note: Recall the definition of the IRR in Section 11-2: The IRR for the project is the discount rate at which NPV equals zero. NPV = C1 C2 Ct CT + + ... + + ... + C0 = 0 (1 + IRR ) (1 + IRR ) 2 (1 + IRR )t (1 + IRR )T

In this perpetuity example, we see: NPV = C C C 3.42 C0 = C0 = 0 => IRR = = = 0.114 IRR C0 30 (1 + IRR )t t =1

Recall in Section 12-1 that Geothermals WACC is 11.4%. Since the rate of return (the IRR) on the expansion project is exactly the same as the WACC, its NPV is zero. To see this, we could also calculate the projects NPV: NPV = C C 3.42 C0 = C0 = 30 = 0 t r 0.114 t = 0 (1 + r )

, where r = the WACC.

assumption in the example: When we calculated Geothermals WACC, we recognized that the companys debt ratio was 30%. (Recall in Section 12-1 that Geothermas D/V is 0.3.) When Geothermals analysts use the WACC to evaluate the new project, they are assuming that the $30 million additional investment would support the issue of addition debt equal to 30% of the investment, or 0.3$30 = $9 million. The remaining $21 million is provided by the shareholders.
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The following table shows how the cash flows would be shared between the debtholders and shareholders: Revenue - Operating Expenses Pretax Operating Cash Flow - Interest Payment (0.08$9) Pretax Cash Flow - Tax at 35% After-tax Cash Flow $8.34 million - 3.08 $5.26 -0.72 $4.54 - 1.59 $2.95 million

Geothermal needs to pay interest of 8% (rD = 8%) of $9 million, which comes to $0.72 million. Shareholders are left with $2.95 million, just enough to give them the 14% return (rE = 14%) that they need on their $21 million investment. (Note that $2.95/$21 = 0.14).

summary in this expansion example: If a project has zero NPV when the expected cash flows are discounted at the WACC, then the projects cash flows are just sufficient to give debtholders and shareholders the returns they require.

question:

the effect of D or D/V

D/V => financial risk (since default risk ) => the risk of debt => rD => rE

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