Fundamentals of Corporate Finance PDF

Fundamentals of Corporate Finance Sixth Edition Chapter 13 The Cost of Capital Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.1 A First Look at the Weighted Average Cost of Capital...

Fundamentals of Corporate Finance Sixth Edition Chapter 13 The Cost of Capital Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.1 A First Look at the Weighted Average Cost of Capital The Firm’s Capital Structure – Capital – Capital Structure Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Figure 13.1 A Basic Balance Sheet Assets Liabilities and Equity Current Assets Debt Long-Term Assets Preferred Stock Blank Equity Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Figure 13.2 Three Capital Structures Source: Authors’ calculations based on publicly available data in 2022. Percentages are based on market value of equity. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.1 A First Look at the Weighted Average Cost of Capital Opportunity Cost and the Overall Cost of Capital Weighted Averages and the Overall Cost of Capital – Weighted Average Cost of Capital (WACC) – Market-Value Balance Sheet Market Value of Equity + Market Value of Debt = Market Value of Assets (13.1) Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.1 A First Look at the Weighted Average Cost of Capital Weighted Average Cost of Capital Calculations – Leverage Unlevered Levered Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.1 A First Look at the Weighted Average Cost of Capital Weighted Average Cost of Capital Calculations – The Weighted Average Cost of Capital: Unlevered Firm rWACC = Equity Cost of Capital Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.1 A First Look at the Weighted Average Cost of Capital Weighted Average Cost of Capital Calculations – The Weighted Average Cost of Capital: Levered Firm (13.2) Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.1a Calculating the Weights in the WACC Problem Suppose McDonalds Inc. has debt with a market value of $18 billion outstanding, and a with a common stock market value of $52 billion, and a book value of $36 billion. Which weights should McDonalds use in calculation of its WACC? Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.1a Calculating the Weights in the WACC Solution Plan Equation 13.2 tells us that the weights are the fractions of McDonalds assets financed with debt and financed with equity. We know these weights should be based on market values because the cost of capital is based on investors’ current assessment of the value of the firm, not their assessment of accounting-based book values. As a consequence, we can ignore the book value of equity. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.1a Calculating the Weights in the WACC Execute Given its $18 billion in debt and $52 billion in equity, the total value of the firm is $70 billion. 18 52 = 25.7% for dept and = 74.3% for equity 70 70 Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.1a Calculating the Weights in the WACC Evaluate When calculating its overall cost of capital, McDonalds will use a weighted average of the cost of its debt capital and the cost of its equity capital, giving a weight of 25.7% to its cost of debt and a weight of 74.3% to its cost of equity. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.2 The Firm’s Costs of Debt and Equity Capital Cost of Debt Capital – Yield to Maturity and the Cost of Debt The Yield to Maturity is the yield that bond purchasers would earn if they held the debt to maturity and received all the payments as promised Can use it to estimate the firms current cost of debt: the yield that investors demand to hold the firm’s debt (new or existing) – Taxes and the Cost of Debt Effective Cost of Debt rD (1 - TC ) (13.3) where TC is the corporate tax rate. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.2 Effective Cost of Debt Problem By using the yield to maturity on AT&T’s debt, we found that its pretax cost of debt is 3.65%. If AT&T’s tax rate is 25%, what is its effective cost of debt? Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.2 Effective Cost of Debt Solution Plan We can use Eq. 13.3 to calculate AT&T’s effective cost of uation debt: rD = 0.0365 (pretax cost of debt ) TC = 0.25 ( corporate tax rate ) Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.2 Effective Cost of Debt Execute AT&T’s effective cost of debt is 0.0365 (1 - 0.25 ) = 0.02738 = 2.738%. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.2 Effective Cost of Debt Evaluate For every new $1000 it borrows, AT&T would pay its bondholders 0.0365 ( $1000 ) = $36.50 in interest every year. Because it can deduct that $36.50 in interest from its income, every dollar in interest saves AT&T 25 cents in taxes, so the interest tax deduction reduces the firm’s tax payment to the government by 0.25 ( $36.50 ) = $9.12. Thus, AT&T’s net cost of $1000 of debt is the $36.50 it pays minus the $9.12 in reduced tax payments, which is $27.38 per $1000 or 2.738%. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.2 The Firm’s Costs of Debt and Equity Capital Cost of Preferred Stock Capital Prefered Dividend Div pfd Cost of Preferred Stock Capital = = Preferred Stock Price Ppfd (13.4) Assume AT&T’s preferred stock has a price of $25.43 and an annual dividend of $1.37. Its cost of preferred stock, therefore, is $1.37 = 5.39%. $25.43 Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.2 The Firm’s Costs of Debt and Equity Capital Cost of Common Stock Capital – Capital Asset Pricing Model From Chapter 12 1. Estimate the firm’s beta of equity. (typically by regressing 60 months of the company’s returns against 60 months of returns for a market proxy such as the S&P 500) 2. Determine the risk-free rate, typically by using the yield on Treasury bills or bonds Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.2 The Firm’s Costs of Debt and Equity Capital Cost of Common Stock Capital – Capital Asset Pricing Model From Chapter 12 3. Estimate the market risk premium, typically by comparing historical returns on a market proxy to contemporaneous risk-free rates 4. Apply the CAPM: Cost of Equity = Risk-Free Rate + Equity Beta ´ Market Risk Premium Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.2 The Firm’s Costs of Debt and Equity Capital (5 of 7) Cost of Common Stock Capital – Capital Asset Pricing Model For example: Assume the equity beta of AT&T is 0.75, the yield on ten-year Treasury notes is 3%, and you estimate the market risk premium to be 6%. AT&T’s cost of equity is 3% + 0.75 ´ 6% = 7.5% Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.2 The Firm’s Costs of Debt and Equity Capital Cost of Common Stock Capital – Constant Dividend Growth Model Dividend (in one year) Div1 Cost of Equity = + Dividend Growth Rate = +g Current Price PE (13.5) Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.2 The Firm’s Costs of Debt and Equity Capital Cost of Common Stock Capital – Constant Dividend Growth Model Assume in early–2022, the average forecast for AT&T’s long-run earnings growth rate was 3.66%. With an expected dividend in one year of $2.12 and a price of $24.56, the CDGM estimates AT&T’s cost of equity as follows (using Eq. 13.5): uation Div1 $2.12 Cost of Equity = +g = + 0.0366 = 0.123 or 12.3% PE $24.56 Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Estimating the Cost of Equity Table 13.1 Estimating the Cost of Equity Blank Capital Asset Pricing Model Constant Dividend Growth Model Inputs Equity beta Current stock price Blank Risk-free rate Expected dividend next year Blank Market risk premium Future dividend growth rate Major Estimated beta is correct Dividend estimate is correct Assumptions Blank Market risk premium is Growth rate matches market accurate expectations Blank CAPM is the correct model Future dividend growth is constant Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.3 Estimating the Cost of Equity Problem Assume the equity beta for Johnson & Johnson (ticker: JNJ) is 0.60. The yield on 10-year treasuries is 3%, and you estimate the market risk premium to be 6%. Furthermore, Johnson & Johnson issues dividends at an annual rate of $4.52. Its current stock price is $175.00, and you expect dividends to increase at a constant rate of 3.5% per year. Estimate J&J’s cost of equity in two ways. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.3 Estimating the Cost of Equity Solution Plan The two ways to estimate J&J’s cost of equity are to use the CAPM and the CDGM. 1. The CAPM requires the risk-free rate, an estimate of the equity’s beta, and an estimate of the market risk premium. We can use the yield on 10-year Treasury notes as the risk-free rate. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.3 Estimating the Cost of Equity Solution Plan The two ways to estimate J&J’s cost of equity are to use the CAPM and the CDGM. 2. The CDGM requires the current stock price, the expected dividend next year, and an estimate of the constant future growth rate for the dividend. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.3 Estimating the Cost of Equity Solution Plan Risk-free rate: 3% Current price: $175.00 Equity beta: 0.60 Expected dividend: $4.52 Market risk premium: 6% Estimated future dividend growth rate: 3.5% We can use the CAPM from Chapter 12 to estimate the cost of equity using the CAPM approach and Eq. 13.5 to uation estimate it using the CDGM approach. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.3 Estimating the Cost of Equity Execute The CAPM says that Cost of Equity = Risk-FreeRate + Equity Beta ´ Market Risk Premium = 3.0% + 0.60 ´ 6% = 6.6% The CDGM says that Dividend(in one year) Cost of Equity = + DividendGrowthRate Current Price $4.52 = + 3.5% = 6.1% $175.00 Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.3 Estimating the Cost of Equity Evaluate According to the CAPM, the cost of equity capital is 6.6%; the CDGM produces a result of 6.1%. Because of the different assumptions we make when using each method, the two methods do not have to produce the same answer—in fact, it would be highly unlikely that they would. When the two approaches produce different answers, we must examine the assumptions we made for each approach and decide which set of assumptions is more realistic. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.3 Estimating the Cost of Equity Evaluate We can also see what assumption about future dividend growth would be necessary to make the answers converge. By rearranging the CDGM and using the cost of equity we estimated from the CAPM, we have Dividend (in one year) DividendGrowthRate = Cost of Equity - Current Price = 6.6% - 2.6% = 4.0% Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.3 Estimating the Cost of Equity (8 of 8) Evaluate Thus, if we believe that J&J’s dividends will grow at a rate of 4.0% per year, the two approaches would produce the same cost of equity estimate. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.3 A Second Look at the Weighted Average Cost of Capital WACC Equation rwacc = rE E % + rpfd P % + rD (1 - TC ) D% (13.6) – For a company that does not have preferred stock, the WACC condenses to: r = r E % + r (1 - T ) D% wacc E D C (13.7) Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.3 A Second Look at the Weighted Average Cost of Capital WACC Equation – For example, in 2022, the market values of AT&T’s common stock, preferred stock, and debt were $173,169 million, $3349 million, and $153,969 million, respectively. – Its total value was, therefore, $173,169 million + $3,349million + $153,969 million = $330,487 million. – Given the costs of common stock (CAPM estimate), preferred stock, and debt we have already computed, AT&T’s WACC(using Eq. 13.6) in 2022 was: uation Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.3 A Second Look at the Weighted Average Cost of Capital WACC Equation æ 173,169 ö æ 3349 ö æ 153,969 ö rWACC = 7.5% ç ÷ + 5.81% ç 330,487 ÷ + 3.65% (1 - 0.25 ) ç 330,487 ÷ è 330,487 ø è ø è ø = 5.3% Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.4 Computing the WACC Problem Assume the expected return on Target’s equity is 11.5%, and the firm has a yield to maturity on its debt of 6%. Debt accounts for 18% and equity for 82% of Target’s total market value. If its tax rate is 25%, what is an estimate of this firm’s WACC? Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.4 Computing the WACC Solution Plan We can compute the WACC using Eq. 13.7. To do so, weuation need to know the costs of equity and debt, their proportions in Target’s capital structure, and the firm’s tax rate. We have all that information, so we are ready to proceed. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.4 Computing the WACC Execute rwacc = rE E % + rD (1 - TC )D% = ( 0.115 )( 0.82 ) + ( 0.06 ) (1 - 0.25 ) (0.18 ) = 0.102 or 10.2% Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.4 Computing the WACC Evaluate Even though we cannot observe the expected return of Target’s investments directly, we can use the expected return on its equity and debt and the WACC formula to estimate it, adjusting for the tax advantage of debt. Target needs to earn at least a 10.2% return on its investment in current and new stores to satisfy both its debt and equity holders. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Figure 13.3 WACCs for Real Companies Source: Authors’ calculations based on publicly available information in 2022. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Figure 13.2 Three Capital Structures Source: Authors’ calculations based on publicly available data in 2022. Percentages are based on market value of equity. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.3 A Second Look at the Weighted Average Cost of Capital Methods in Practice – Net Debt Net Debt = Debt - Cash and Risk-Free Securities (13.8) æ Market Value of Equity ö æ Net Debt ö rWACC = rE ç ÷ + rD (1 - TC ) ç ÷ è Enterprise Value ø è Enterprise Value ø Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.3 A Second Look at the Weighted Average Cost of Capital Methods in Practice – The Risk-Free Interest Rate Most firms use the yields on long-term treasury bonds – The Market-Risk Premium Since 1926, the S&P 500 has produced an average return of 7.7% above the rate for one-year Treasury securities Since 1965, the S&P 500 has shown an excess return of only 5.0% over the rate for one-year Treasury securities Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.4 Using the WACC to Value a Project Levered Value – The value of an investment, including the benefit of the interest tax deduction, given the firm’s leverage policy WACC Method – Discounting future incremental free cash flows using the firm’s WACC, which produces the levered value of a project Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.4 Using the WACC to Value a Project Levered Value FCF1 FCF2 FCF3 V = FCF0 + 0 L + + +... 1 + rwacc (1 + rwacc ) (1 + rwacc ) 2 3 (13.9) Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.5 The WACC Method Problem Suppose Starbucks is considering introducing a new low- calorie blended coffee drink called FrapZero. The firm believes that the drink’s flavor and appeal to calorie-conscious drinkers will make it a success. The cost of bringing the drink to market is $200 million, but Starbucks expects first-year incremental free cash flows from FrapZero to be $100 million and to grow at 3% per year thereafter. If Starbucks’s WACC is 7.9%, should it go ahead with the project? Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.5 The WACC Method Solution Plan We can use the WACC method shown in Eq. 13.9 to uation value FrapZero and then subtract the up-front cost of $200 million. We will need Starbuck’s WACC, which is 7.9%. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.5 The WACC Method Execute The cash flows for FrapZero are a growing perpetuity. Applying the growing perpetuity formula with the WACC method, we have FCF1 $100million V0L = FCF0 + = -$200 million + = $1,840.8million($1.8 billion) rWACC - g 0.079 - 0.03 Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.5 The WACC Method Evaluate The FrapZero project has a positive NPV because it is expected to generate a return on the $200 million far in excess of Starbuck’s WACC of 7.9%. As discussed in Chapter 8, taking positive-NPV projects adds value to the firm. Here, we can see that the value is created by exceeding the required return of the firm’s investors. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.4 Using the WACC to Value a Project Key Assumptions – Average Risk We assume initially that the market risk of the project is equivalent to the average market risk of the firm’s investments – Constant Debt-Equity Ratio We assume that the firm adjusts its leverage continuously to maintain a constant ratio of the market value of debt to the market value of equity Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.4 Using the WACC to Value a Project Key Assumptions – Limited Leverage Effects We assume initially that the main effect of leverage on valuation follows from the interest tax deduction and that any other factors are not significant at the level of debt chosen Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.4 Using the WACC to Value a Project Key Assumptions – Assumptions in Practice These assumptions are reasonable for many projects and firms The first assumption is likely to fit typical projects of firms with investments concentrated in a single industry The second assumption reflects the fact that firms tend to increase their levels of debt as they grow larger The third assumption is especially relevant for firms without very high levels of debt where the interest tax deduction is likely to be the most important factor affecting the capital budgeting decision Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.4 Using the WACC to Value a Project WACC Method Application: Extending the Life of an AT&T Facility – Suppose AT&T is considering an investment that would extend the life of one of its chemical facilities for four years – The project would require upfront costs of $6.67 million plus a $24 million investment in equipment – The equipment will be obsolete in four years and will be depreciated via straight-line over that period Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.4 Using the WACC to Value a Project WACC Method Application: Extending the Life of an AT&T Facility – During the next four years, however, AT&T expects annual sales of $60 million per year from this facility – Material costs and operating expenses are expected to total $25 million and $9 million, respectively, per year – AT&T expects no net working capital requirements for the project, and it pays a tax rate of 25%. – AT&T’s WACC, from Section 13.3, is 5.3%. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Expected Free Cash Flow from G E’s Facility Project Table 13.3 Expected Free Cash Flow from AT&T’s Facility Project Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.4 Using the WACC to Value a Project WACC Method Application: Extending the Life of an AT&T Facility 21 21 21 21 V = 0 L + 2 + 3 + 4 = $73.95 million 1.053 1.053 1.053 1.053 NPV = $73.95 million - $29.00 million = $44.95 million Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.4 Using the WACC to Value a Project Summary of WACC Method 1. Determine the incremental free cash flow of the investment 2. Compute the weighted average cost of capital using Eq. 13.6 uation 3. Compute the value of the investment, including the tax benefit of leverage, by discounting the incremental free cash flow of the investment using the WACC Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.5 Project-Based Costs of Capital Cost of Capital of a New Acquisition – Suppose AT&T is considering acquiring Netflix, a company that is focused on streaming offerings – Netflix faces different market risks than AT&T does in its lines of business – What cost of capital should AT&T use to value a possible acquisition of Netflix? Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.5 Project-Based Costs of Capital Cost of Capital of a New Acquisition – Because the risks are different, AT&T’s WACC would be inappropriate for valuing Netflix – Instead, AT&T should calculate and use Netflix’s WACC when assessing the acquisition Blank Beta Cost of Cost of % Equity % Debt WACC Equity Debt Netflix 1.28 10.7% 3.7% 88% 12% 9.7% Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.5 Project-Based Costs of Capital Divisional Costs of Capital – Now assume AT&T decides to create a streaming division internally, rather than buying Netflix – What should the cost of capital for the new division be? If AT&T plans to finance the division with the same proportion of debt as is used by Netflix, then AT&T would use Netflix’s WACC as the WACC for its new division Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.6 A Project in a New Line of Business Problem You are working for Microsoft evaluating the possibility of selling energy drinks. Microsoft’s WACC is 8.1%. Energy drinks would be a new line of business for Microsoft, however, so the systematic risk of this business would likely differ from the systematic risk of Microsoft’s current business. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.6 A Project in a New Line of Business Problem As a result, the assets of this new business should have a different cost of capital. You need to find the cost of capital for the energy drink business. Assuming that the risk-free rate is 3% and the market risk premium is 6%, how would you estimate the cost of capital for this type of investment? Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.6 A Project in a New Line of Business Solution Plan The first step is to identify a company operating in Microsoft’s targeted line of business. Monster Beverage Corporation is a well-known energy drink company. In fact, that is its sole business. Thus, the cost of capital for Monster would be a good estimate of the cost of capital for Microsoft’s proposed energy drink business. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.6 A Project in a New Line of Business Solution Plan Many Web sites are available that provide betas for traded stocks, including http://finance.yahoo.com. Suppose you visit that site and find that the beta of Monster stock is 0.98. With this beta, the risk-free rate, and the market risk premium, you can use the CAPM to estimate the cost of equity for Monster. Fortunately for us, Monster has no debt, so its cost of equity is the same as its cost of capital for its assets. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.6 A Project in a New Line of Business Execute Using the CAPM, we have: Monster's Cost of Equity = Risk-FreeRate + Monster's Equity Beta ´ MarketRisk Premium = 3% + 0.98 ´ 6% = 8.9% Because Monster has no debt, its WACC is equivalent to its cost of equity. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.6 A Project in a New Line of Business Evaluate If we had used the 8.1% cost of capital that is associated with Microsoft’s existing business, we would have mistakenly used too low of a cost of capital. That could lead us to go ahead with the investment, even if it truly had a negative NPV. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved 13.6 When Raising External Capital Is Costly Issuing new equity or bonds carries a number of costs – Issuing costs should be treated as cash outflows that are necessary to the project – They can be incorporated as additional costs (negative cash flows) in the NPV analysis Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.7 Evaluating an Acquisition with Costly External Financing Problem You are analyzing AT&T’s potential acquisition of Netflix. AT&T plans to offer $150 billion as the purchase price for Netflix, and it will need to issue additional debt and equity to finance such a large acquisition. You estimate that the issuance costs will be $800 million and will be paid as soon as the transaction closes. You estimate the incremental free cash flows from the acquisition will be $11 billion in the first year and will grow at 3% per year thereafter. What is the NPV of the proposed acquisition? Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.7 Evaluating an Acquisition with Costly External Financing Solution Plan We know from Section 13.5 that the correct cost of capital for this acquisition is Netflix’s WACC. We can value the incremental free cash flows as a growing perpetuity: FCF1 PV = r -g where FCF1 = $11 billion r = Netflix’s WACC = 0.097 (from Figure 13.3) g = 0.03 Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.7 Evaluating an Acquisition with Costly External Financing Solution Plan The NPV of the transaction, including the costly external financing, is the present value of this growing perpetuity net of both the purchase cost and the transaction costs of using external financing. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.7 Evaluating an Acquisition with Costly External Financing Execute Noting that $800 million is $0.8 billion, $11 NPV = -$150 - $0.8 + = $13.4billion 0.097 - 0.03 Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved Example 13.7 Evaluating an Acquisition with Costly External Financing Evaluate It is not necessary to try to adjust Netflix’s WACC for the issuance costs of debt and equity. Instead, we can subtract the issuance costs from the NPV of the acquisition to confirm that the acquisition remains a positive-NPV project even if it must be financed externally. Copyright © 2024, 2021, 2018 Pearson Education, Inc. All Rights Reserved