Unit 10 - Slides Only - Unit 10 The Weighted Average Cost...

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2016-11-16 1 1 Unit 10 The Weighted Average Cost of Capital Textbook Chapter 13 ADMS 3530 Online Section Prepared by Lois King Please make sure you have read Ch. 13 of your text. Have your calculator available 2 Unit 6 - NPV is the best investment criteria for evaluating projects. NPV = - CF 0 + CF 1 + CF 1 + CF 2 …+ … CF n (1+ r) 1 (1+ r) 1 (1+r) 2 (1+r) n Units 7 & 8 – focused on numerator 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 10 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 10 Background Unit 9, Part 1 Total risk of a security can be measured by standard deviation or variance. Unit 9, Part 2 Only systematic risk is important CAPM: R j = R f + j (R m – R f ) Unit 10 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 10.1 - Rationale for Calculating WACC 10.2 - Calculating Market Values for Securities 10.3 - Calculating Required Rates of Return 10.4 - Calculating WACC – An Example 10.5 - Miscellaneous Issues 10.6 - Summary 6
2016-11-16 2 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 10.1 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)? Answer: is that we must use the weighted-average cost of capital, WACC = 8 10.1 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 10.1 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

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