19 - FIN 300 Fundamentals of Finance Weighted Average Cost...

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FIN 300 Fundamentals of Finance Weighted Average Cost of Capital (WACC) Chapter 13 1 FIN 300 - WACC
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Firm and Project Discount Rate So, far we’ve looked at firm (and project) value as the discounted present value of the free cash flows In Chapter 10, we learned how, given the cash flows and discount rate, we could calculate the NPV and IRR of a firm’s project investments In Chapter 11, we learned how to calculate the free cash flows of the firm or project Now, in Chapter 13, we will learn how to calculate the discount rate (known as the “weighted average cost of capital,” or “WACC”) FIN 300 - WACC 2
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WACC Calculation Example: Let’s assume that a firm is financed with a 50/50 mix of debt and equity The required rate of return of the shareholders is 20% The required rate of return of the debtholders (let’s assume they’re bondholders) is 10% What is the overall required rate of return required for the firm? FIN 300 - WACC 3
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WACC Calculation Your first impulse might be to “split the difference” between 10% and 20% and say that the overall average required rate of return for the firm is 15% That would be wrong! – Why? We are calculating the required rate of return applied to the free cash flows of the firm Remember, that the free cash flows don’t include the effects of interest or the interest tax shield Here is where we include them! FIN 300 - WACC 4
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Cost of Capital We are trying to calculate a “cost of capital” for the firm This is not a dollar cost, such as $1M This is a required rate of return (a “hurdle” rate, so to speak) What we need is the rate of the return that the
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