Corporate Finance Lecture 9 PDF

SKEMA BUSINESS SCHOOL Lecture 9 The weighted average cost of capital WACC Reading requirements Chapter 12.1–12.7 Risk, cost of capital and capital budgeting Corporate Finance, European edition, by Hillier, Ross, Westerfield, Jaffe a...

SKEMA BUSINESS SCHOOL Lecture 9 The weighted average cost of capital WACC Reading requirements Chapter 12.1–12.7 Risk, cost of capital and capital budgeting Corporate Finance, European edition, by Hillier, Ross, Westerfield, Jaffe and Jordan, McGraw-Hill ed., 4th. Get access to the book @ https://k2.skema.edu in the course Corporate Finance 2  Weighted average cost of capital How does a firm remunerate its investors? How do shareholders and bondholders make a return on their investment? 1°)Cash raised 2°)Cash invested from investors Financial in projects resources reinvested 4°a)Cash Firm's Financial operations manager 3°)Cash generated 4°b)Cash returned by operations to investors 3  Weighted average cost of capital The balance sheet of a firm tells us what is weighted average cost of capital (WACC). Cost = kE Equity Value = VE Return = r Assets Cost = kD Debt Value = VD 4 Weighted average cost of capital The weighted average cost of capital (WACC) is : VE VD k  kE   kD  (1 TC ) VE VD VE VD KE : Cost of equity VE : Market value of equity KD : Cost of debt VD : Market value of debt TC : Corporate Tax Remember : the cost of debt is tax deductible and you must use market value for equity and debt. To create value, the return on the assets (r) must be sufficient to cover the cost of financing (k) 5  Weighted average cost of capital BALANCE SHEET EQUITY ASSETS LIABILITIES TOTAL VALUE OF THE FIRM TOTAL VALUE OF THE FIRM TOTAL VALUE OF THE FIRM = TOTAL VALUE OF ASSETS TOTAL VALUE OF THE FIRM = TOTAL VALUE OF EQUITY AND LIABILITIES 6 Weighted average cost of capital The WACC is the discount rate you must use to estimate the net present value of an investment or the value of a firm. 7 Estimating the value of a firm 1. Consider operating cash flows EBIT x (1 – Tc) = NOPAT Add back depreciation Deduct any net investment required, if any Do not forget the change in NWC Change in (account receivable + inventory – account payable) 2. Estimate the market value of debt and the cost of debt 3. Estimate the market value of equity and the cost of equity 4. Compute the WACC 5. Discount the operating cash flows at the WACC and you get the total value of the firm 6. In order to find the equity value, you can deduct the value of debt from the total value 8 Estimating the value of Microsoft Microsoft revenues have been growing at between 15% CAGR From 2017 to 2022. After carefully analyzing its perspectives, we think that Microsoft will be able to keep its competitive advantage but will grow at a slightly slower pace of 11% over the next the next 10 years. We know that its latest annual sales were $198 270 millions (June 2022), and got the following data Net Operating Profit margin is 42,1% Effective tax rate is 5,5% Depreciation rate is 7,3% Investment rate is 12% Working capital rate is 1,2% Its weighted average cost of capital is 8,9%. Number of shares outstanding: 7.464 billion Based on these information and using the FCF approach, compute the intrinsic value to shareholders of Microsoft and compare to its current stock price of $247,49. Do you think it is worth to buy it ? 9  Estimating the value of Microsoft Change in Net Working Discount Discounted Period Revenues NOP Taxes NOPAT Deprec. Working FCFF Invest. Capital factor FCFF Capital 30/06/2022 198 270 2 379 30/06/2023 220 203 92 705 5 099 87 607 16 075 26 424 2 642 263 76 994 0.92 70 701 30/06/2024 244 561 102 960 5 663 97 298 17 853 29 347 2 935 292 85 511 0.84 72 105 30/06/2025 271 615 114 350 6 289 108 061 19 828 32 594 3 259 325 94 970 0.77 73 537 30/06/2026 301 661 126 999 6 985 120 014 22 021 36 199 3 620 361 105 476 0.71 74 996 30/06/2027 335 031 141 048 7 758 133 290 24 457 40 204 4 020 400 117 143 0.65 76 485 30/06/2028 372 092 156 651 8 616 148 035 27 163 44 651 4 465 445 130 102 0.60 78 004 30/06/2029 413 252 173 979 9 569 164 410 30 167 49 590 4 959 494 144 494 0.55 79 552 30/06/2030 458 966 193 225 10 627 182 598 33 505 55 076 5 508 549 160 478 0.51 81 132 30/06/2031 509 737 214 599 11 803 202 796 37 211 61 168 6 117 609 178 230 0.46 82 743 30/06/2032 566 124 238 338 13 109 225 230 41 327 67 935 6 793 677 197 945 0.43 84 385 Residual 2 530 672 1 078 840 See the details on K2 "Lecture 10 FCF Valuation Microsoft.xlsx" 10 Estimating the value of Microsoft Discounted Excess Return Period FCFF 773 641 Discounted Corporate Residual Value 1 078 840 Short-Term Assets 169 684 Total Corporate Value 2 022 164 Less Debt -47 032 Less Short-Term Liabilities -95 082 Total Value to Common Equity 1 880 050 Intrinsic Stock Value $251.88 See the details on K2 "Lecture 10 FCF Valuation Microsoft.xlsx" 11 Estimating the value of Microsoft See the details on K2 "Lecture 10 FCF Valuation Microsoft.xlsx" 12