Cost of Equity Method Estimated Value
SML 8.80%
DCF 9.75%
Average (RE) 9.28%
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Eastman Chemical Bond Data
Source: http://www.sec.gov
Go to the SEC website to get book value information from the firm’s most recent 10Q
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Eastman Chemical Cost of Debt
• For Eastman, the cost of debt is similar when using either
book values or market values.
Avg. of YTM = RD
Go to FINRA’s Market Data Center at http://finra-markets.morningstar.com/MarketData/ to get market
information on Eastman Chemical’s bond issues.
✓ Enter “Eastman Ch” to find the bond information. ✓ Note that you may not be able to find information on all bond issues due to the illiquidity of the bond
market.
Go to the SEC website to get book value information from the firm’s most recent 10Q.
Market values of debts: 1661 mil
The average YTM is the weighted average of the yields on the bond issues, weighted by the percent of
each issue’s market value on the total market value of outstanding debt.
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Capital structure weights (market values):
E = 136.92 million x $53.74 = $7.358 billion
D = 1.661 billion
V = $7.358 + 1.661 = 9.019 billion
E/V = 7.358 / 9.019 = .82
D/V = 1.661 / 9.019 = .18
3.81 = RD 9.28 = RE Tax rate (assumed) = 35%
WACC = .82(9.28%) + .18(3.81%)(1-.35)
= 8.02%
Eastman Chemical – 10 WACC
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Risk-Adjusted WACC
• Using the WACC as our discount rate is only appropriate for projects that have the same risk as the firm’s current operations.
• If we are looking at a project that does NOT have the same risk as the firm, then we need to determine the appropriate discount rate for that project.
• Divisions also often require separate discount rates.
It is important to know that a single corporate WACC is not very useful for companies that have several
disparate divisions.
A firm’s WACC is an average applicable only to projects with the same risk.
If a proposed project has a risk significantly different from the firm’s average projects, then the WACC
should be adjusted to reflect that additional risk.
Eg. GE
If GE’s WACC was used for every division, then the riskier divisions would get more investment capital
and the less risky divisions would lose the opportunity to invest in positive NPV projects.
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Using WACC for All Projects
• What would happen if we use the WACC for all projects regardless of risk?
• Assume the WACC = 15%
Project Required Return IRR
A 20% 17%
B 15% 18%
C 10% 12%
If you use the firm’s WACC across divisions, then riskier divisions will receive more funding and less
risky divisions will have to forgo what would be good projects if the appropriate discount rate were used.
This will lead to an increase in risk for the overall firm.
Which projects would be accepted if you used the WACC for the discount rate? Compare 15% to IRR and
accept projects A and B.
Which projects should be accepted if you use the required return based on the risk of the project? Accept
B and C.
So, what happened when we used the WACC? We accepted a risky project that we shouldn’t have and
rejected a less risky project that we should have accepted. What will happen to the overall risk of the firm
if the company does this on a consistent basis? The firm will become riskier. What will happen to the
firm’s cost of capital as the firm becomes riskier? It will increase (adjusting for changes in market returns
in general) as well.