ADMS 3530 Winter 2012 – Professor Lois King
Lecture 11 – The Cost of Capital – Mar 20
Unit 11 Background
− This discount rate, ‘r’, also known as the cost of capital and has 3 components:
o Real rate of return in the economy.
o Rate of inflation.
o Risk premium.
− Unit 9
o Total risk of a security can be measured by standard deviation or variance.
− Unit 10
o Only systematic risk is important.
− Unit 11
o If the firm has issued debt or preferred shares ▯the weighted average cost of
capital (WACC) must be used as cost of capital.
11.1 Rationale for Calculating WACC
− If firm is all equity financed ▯jse R as the cost of capital for the firm.
o Reason – If the firm is allequity financed, then:
Shareholders own 100% of the firm’s assets, and
The return required by the shareholders will equal the rate of return earned
on the firm’s existing operations.
o We can use the j to discount new projects IF
The risk of the new project is the same risk level as the firm’s existing
o Calculate the market value of each of the firm’s securities.
o Calculate the proportion of market value that each security contributes to the total
value of the firm’s capital structure;
o Determine the required rate of return on each security;
o Calculate the weighted average of these returns.
11.2 Calculating Market Values for WACC
o D/V = % of debt (or weight of debt) in the firm’s capital structure;
o P/V = % that preferred shares makeup of the firm’s total value. o E/V = % that common shares makeup the firm’s total value.
− The correct weights (D/V, P/V, E/V) are market values (not book values!) for WACC.
− Reason – The cost of capital (and thus the discount rate) must be based on what investors
are actually willing to