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Estimating the Cost of Capital
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WACC and Market Capitalization
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Let s look at the WACC and market capitalization for a company that has debt, preferred stock, and common stock outstanding. As our test case, we take a freeze-frame look at the capital structure of Consolidated Edison of New York (ED: www.ConEdison.com/ ), an electric utility provider that has plenty of debt and preferred stock, along with common stock. After studying ConEd s balance sheet, we return to our valuation of Cisco, which has a boring capital structure consisting solely of common stock. Let s examine ConEd s capital structure as of December 31, 2001, and find the amounts of debt, preferred stock, and common stock outstanding. We look at its balance sheet (Exhibit 6-1) and income statement (Exhibit 6-2) to get the necessary information. From the balance sheet, we find that ConEd has $5501 million of outstanding long-term debt. If we want a detailed description of a company s capital structure, we can access online its regulatory filings at the SEC. We examine Note B of ConEd s 10K for 2001 filed with the SEC through its EDGAR service. We see that ConEd has 25 different taxable debentures aggregating $4.105 billion with maturities from 2002 to 2041 and interest rates ranging from 6.375 percent to 8.125 percent. ConEd also is the obligor in $1.191 billion of tax-exempt debt that was issued on ConEd s behalf by the New York State Energy Research and Development Authority. The 13 tax-exempt issues have maturities from 2014 to 2036 and interest rates ranging from 1.81 percent to 7.5 percent. ConEd also has at least four series of preferred stock outstanding with an aggregate face value of $269.6 million. Is ConEd s capital structure confusing enough The income statement indicates that ConEd has 212.1 million average shares outstanding basic, and 212.9 million average shares outstanding diluted. We generally use the diluted shares outstanding when we look at capital structure and value a stock. This larger number better takes into account the effects of stock options and of convertible debt and preferred stock. ConEd s balance sheet shows that the book value of the common stock outstanding is $5666 million. On August 26, 2002, the stock of ConEd closed at a price of $42.53 per share. The market equity of ConEd s stock is: 212.9 million shares outstanding * $42.53 $9,054 million
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EXHIBIT 6-1
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Financial theory states that the market capitalization of a company is equal to the total market value, not book value, of the outstanding debt, preferred stock and common stock of the company. Market Capitalization Market Value (Common Stock
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Preferred Stock
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Debt)
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The FCFF approach uses the various market values to calculate a company s market capitalization, along with debt and equity weightings. To illustrate this point, consider the book value $5666 million ver-
Estimating the Cost of Capital
EXHIBIT 6-2
ConEd Income Statement
sus market value $9054 million of ConEd s common stock. ConEd s book value versus market value ratio ($5666/$9054) is 62.6 percent. The book value of debt and preferred stock is an accounting measure that relates to how much money was raised by the company when each security initially was issued. The book value of common stock is also an accounting measure that relates to the amount of money raised when the stock was issued, plus the amount of aggregate earnings that have been retained over the life of the company. The market value of debt and preferred and common stock is the price at which the specific obligation would trade in today s market, times the amount outstanding. Because of the frequent trading of stocks and the fact that stock prices are readily observable, it s easy to determine the market value of common stock. Since debt and preferred stock trade less frequently and often only in the dealer-to-dealer
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