The weighted average cost of capital and company valuation
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| Cost of Capital | The return the firm’s investors could expect to earn if they invested in securities with comparable degrees of risk.
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| Capital Structure | The firm’s mix of long term debt and equity financing.
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| 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.
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| 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.
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| 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.
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| 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.
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| Market Value of Bonds | PV of all coupons and par value discounted at the current YTM.
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| Market Value of Equity | Market price per share multiplied by the number of outstanding shares.
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| Interpreting WACC | The WACC is an appropriate discount rate only for a project that is a carbon copy of the firm's existing business
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| 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.
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| Debt has two costs. | 1)return on debt and
2)increased cost of equity demanded due to the increase in risk
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| 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.
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| 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).
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