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University of Guelph
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Economics
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ECON 2560
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Tahsin Mehdi
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Chapter 13

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Economics

ECON 2560

Tahsin Mehdi

Summer

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Chapter 13 ECON 2560
The Weighted-Average Cost of Capital & Company Valuation
Capital Structure: A firm’s mix of debt & equity financing
THE WEIGHTED-AVERAGE COST OF CAPITAL
The company cost of capital is defined as the opportunity cost of capital for the firm’s existing assets
We use it to value new assets that have the same risk as the old ones
Company’s cost of capital is the minimum acceptable rate of return when the firm expands by
investing in average-risk projects
When the firm invests rather than returns cash to shareholders, the shareholders lose the opportunity
to invest in financial markets
The expected rates of return on investments in financial markets determine the cost of capital for
corporate investments
The company cost of capital is the opp. Cost of capital for the company as a whole
The weighted-average cost of capital formula adjusts for if company raises different types of debt &
equity
Calculating Company Cost of Capital as a Weighted Average
Most companies issue debt as well as equity so their cost of capital depends on both the cost of debt &
cost of equity
In this case the company cost of capital is a weighted average of the returns demanded by the debt &
equity investors.
Total Market Value (V) = Market Value Outstanding Debt (D) + Market Value Outstanding Equity (E)
Company Cost of Capital = weighted average of debt & equity returns
Debt holders need income of: (r debt D)
Equity Investors need income of (r equity D)
The total income that is needed is (r x D) + (r X D)
debt equity
To calculate the return needed on the assets, simply divide income by investments….
Rassets Total Income___ (rdebt D) + (requity D) = D E
Value of Investment = V ( V x rdebt) + ( V x equity)
Use Market Weights, Not Book Weights
Market values often differ from the values recorded by accountant in the company’s book
If investors recognize company’s excellent prospects, the market value of equity may be much
higher than book value and the debt ratio will be lower when measured in terms of market values
rather than book values
Financial managers use book debt-to-value ratios for various other purposes and sometimes they
accidently look to the book ratios when calculating weights for the company cost of capital
This is a mistake b/c the company cost of capital measures what investors want from the company
and depends on how THEY value the companies securities and that value depends on future profits
& cash flows not on accounting history
Book values measure only cumulative historical outlays… they generally don’t measure market values
accurately Taxes & The Weighted-Average Cost of Capital
When you calculate a projects NPV, you need to discount the cash flows AFTER tax b/c the after-tax
cash flows are the relevant project cash flows
The interest payments on the debt companies are financed by are deducted from the income before
tax is calculated
Therefore the cost to the company of an interest payment is reduced by the amount of this tax
saving
After-tax cost of debt = (1 – tax rate) x pretax cost
= (1 – Tc) xdebt
The Weighted-average cost of capital: Expected rate of return on a portfolio of all the firm’s securities,
adjusted for tax savings due to interest payments
What if there are 2 or more sources of financing?
Simply calculate the weighted-average after-tax return of each security type
WACC for a firm with common stock, bonds and preferred stocks….
WACC = [ D x (1 – T )cr debt + [ P x preferred+ [ E x equity
V V V
CALCULATING REQUIRED RATES OF RETURN
The Expected Return on Bonds
As long as the company doesn’t go belly-up, the rate of return to investors in the yield to maturity
offered on the bond
If there is any chance firm won’t be able to repay the debt, the yield to maturity will be the most
favorable outcome but the expected rate of return will be lower
The Expected Return on Common Stock
Estimates Based on the Capital Asset Pricing Model
Expected return on stock = risk free interest rate + [Stock’s beta x Expected market risk premium]
To implement CAPM you need the stock’s beta, the current risk-free interest rate and an estimate of
the market risk premium
Estimates Based on the Dividend Discount Model
Whenever you’re given an estimate of the expected return on common stock, always look for ways to
check whether it is reasonable
One check is if the cost of equity is greater than the cost of debt b/c equity of firm is riskier than any of
its debt
Another check can be done using dividend discount model
P = DIV ___
0 1
requity g P0= current stock price
DIV 1 the forecast dividen

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