# Unit11_SlidesOnly_Internet - Unit 11 THE WEIGHTEDAVERAGE...

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1 Unit 11 THE WEIGHTED- AVERAGE COST OF CAPITAL (CHAPTER 13) ADMS 3530 2013-14 INTERNET VERSION Author: Lois King
Unit 11 Pre-work Please make sure you have read Chapter 13 of your text. 2
Unit 11 Background NPV = - CF 0 + CF 1 + CF 1 + CF 2 …+ … CF n (1+ r) 1 (1+ r) 1 (1+r) 2 (1+r) n Units 6, 7 & 8 – focused on numerator NPV is the best investment criteria for evaluating projects. Which cash flows belonged in the numerator ( CF i ) How sensitive our project NPV was if our estimates were incorrect. Units 9, 10 & 11 – focused on denominator Trying to calculate the discount rate, r . 3
Unit 11 Background This discount rate, “ r ”, also known as the Cost of Capital and has 3 components : 1. Real rate of return in the economy. 2. Rate of inflation (Note: 1 +2 = Nominal risk-free rate or T-bill rate) 3. Risk premium - very difficult to calculate! 4
Unit 11 Background Unit 9 Total risk of a security can be measured by standard deviation or variance. Unit 10 Only systematic risk is important CAPM: R j = R f + j (R m – R f ) Unit 11 If firm is all equity financed  use R j as the cost of capital If the firm has issued debt or preferred shares  the weighted average cost of capital ( WACC ) must be used as cost of capital. 5
Unit 11 - Outline 11.1 - Rationale for Calculating WACC 11.2 - Calculating Market Values for Securities 11.3 - Calculating Required Rates of Return 11.4 - Calculating WACC – An Example 11.5 - Miscellaneous Issues 11.6 - Summary 6
11.1 Rationale for Calculating WACC CAPM: R j = R f + j (R m – R f ) If firm is all equity financed  use R j as the cost of capital for the firm. Reason : If the firm is all-equity 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. W e can using Rj to discount new projects IF The risk of the new project is the same risk level as the firm's existing business 7
11.1 Rationale for Calculating WACC Question : What do we use as a cost of capital when the firm uses many different methods of financing? E.g. a mix of debt, equity, & preferred shares? (when the firm’s Capital Structure is a mix of long-term financing)? =
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11.1 Rationale for Calculating WACC WACC = A firm’s cost of capital is the weighted average of returns demanded by debt, preferred and equity investors. Where V is the market value of the entire firm D, P, & E are the market value of the debt, preferred and equity components.  V = D + E + P Note : r debt is multiplied by (1-T c ) to reflect the fact that interest expense, unlike dividends , can be deducted from a firm’s income to reduce taxes payable. 9 ] [ ] [ ] ) 1 ( [ equity preferred debt r V E r V P r T V D c
11.1 Steps for Calculating WACC Step 1 Calculate the market value of each of the firm's securities Step 2 Calculate the proportion of market value that each security contributes to the total value of the firm's capital structure; Step 3 Determine the required rate of return on each security ; Step 4 Calculate the weighted average of these returns 10