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Finance Chpt 8

The weighted average cost of capital and company valuation

QuestionAnswer
Cost of Capital The return the firm’s investors could expect to earn if they invested in securities with comparable degrees of risk.
Capital Structure The firm’s mix of long term debt and equity financing.
Weighted Average Cost of Capital (WACC) The expected rate of return on a portfolio of all the firm’s securities, adjusted for tax savings due to interest payments.
Company cost of capital Weighted average of debt and equity returns. Taxes are an important consideration in the company cost of capital because interest payments are deducted from income before tax is calculated.
Calculating Cost of Capital Step 1. Calculate the value of each security as a proportion of the firm’s market value. Step 2. Determine the required rate of return on each security. Step 3. Calculate a weighted average after tax return on the debt and the return on the equity.
Measuring Capital Structure Use the market value of securities (not the book value) to calc WACC. BVs do not rep the true market value of a firm’s securities. The cost of capital must be based on what investors are actually willing to pay for the company’s outstanding securities.
Market Value of Bonds PV of all coupons and par value discounted at the current YTM.
Market Value of Equity Market price per share multiplied by the number of outstanding shares.
Interpreting WACC The WACC is an appropriate discount rate only for a project that is a carbon copy of the firm's existing business
Define the two costs of debt financing The explicit cost of debt is the rate of interest bondholders demand. The implicit cost is the required increase in return from equity.
Debt has two costs. 1)return on debt and 2)increased cost of equity demanded due to the increase in risk
If the firm increases its debt ratio then ... both the debt and the equity will become more risky. The debtholders and equityholders require a higher return to compensate for the increased risk.
Valuing a Business The value of a business or project is usually computed as the discounted value of Free cash flow out to a valuation horizon (H).
Created by: wguate