06-WACC - FIN 231 The Weighted Average Cost of Capital 1...

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Finance 231 - WACC 75 FIN 231 The Weighted Average Cost of Capital 1. Capital Components Our goal is to determine the cost of capital for capital budgeting decisions. 1. Spontaneously Generated Funds S PONTANEOUSLY G ENERATED F UNDS - Short-Term Non- Interest Bearing Liabilities: Accounts Payable, Accrued Wages and Accrued Taxes. These accounts represent spontaneously generated funds. They fluctuate directly with sales. The credit generated by these accounts is subtracted from the funds otherwise necessary to finance the project. Example: Increase in Fixed Assets $1,500,000 Increase in Current Assets $500,000 Less: Increase in Liabs. (200,000) Increase in Net Worth: 300,000 Net Funds Req. for Project $1,800,000 We are only concerned with the cost of nonspontaneous capital. Spontaneously generated capital is NOT included in the WACC.
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Finance 231 - WACC 76 2. Short-Term Debt If the firm uses short-term debt to finance temporary funds needs, it should not be included in the WACC. If, however, short-term debt is used as a permanent financing source for long-term investments, then it should be included in the WACC. For instance, a firm might use Commercial Paper issuances to permanently finance its long-term investments. Obviously, this type of financing provides cost benefits, but can present a substantial interest-rate gamble. Summary Relevant Cost of Capital Components Include: a. Short-term interest-bearing debt used for permanent financing; b. all long-term debt; c. all preferred stock; and d. all common equity.
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Finance 231 - WACC 77 Taxes: Stockholders are concerned with after-tax cash flows. As a result, the WACC must be calculated on an after-tax basis. Historical versus New, or Marginal, Costs The WACC is used to make financing decisions about new projects. As a result, only marginal costs should be used to establish the WACC. Capital Structure The appropriate weights given to each component of financing are determined by the firm’s target capital structure; these weights may not be the same as those currently observed. Weighted Average Cost of Capital (WACC): ) ( E D E ) 1 )( ( E + D D = WACC E c D r t r + + , where D = market value of debt E = market value of equity (price * # common shares out) r D = cost of debt r E = cost of equity t c = marginal federal-plus-state tax rate faced by the firm
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Finance 231 - WACC 78 The WACC is simply the weighted average cost of each dollar of capital acquired by the firm. Or, the minimum return that will be required by investors for a project having the same risk as the overall firm. If you think of the firm as a portfolio of existing projects, the WACC represents the return investors require from their investment in the portfolio. It is important to keep in mind that the WACC may not apply to any specific project undertaken by the firm. Also, in general, the cost of capital is a reflection of the cost of funds (i.e., required return) for a project under consideration – it is not a historical estimate of the cost of funds.
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Finance 231 - WACC 79 What goes into the model?
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