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Unformatted text preview: Lecture 10 Cost of Capital 2 Value of the Firm r The total value of the assets owned by the firm (V) will be equal to the sum of c Market value of debt (D) and c Market value of equity (E) V=D+E 3 Project evaluation r Two key factors in project evaluation are c Future cash flow estimation c Discount rate r The appropriate discount rate (or cost of capital) is the investors’expected return c It cannot be observed; must be estimated r Most common approach is to use the weightedaverage cost of capital (WACC) 4 WACC r Investors comprise: c Equity investors c Debt investors r We previously calculated expected return {E(r)} using the firm’s beta and CAPM c This represents the cost of equity capital r Most companies are also financed by debt c Therefore we need to also calculate the cost of debt •EgCost of loans, bonds 5 Weighted Average Cost of Capital r To estimate WACC for a project, the first step is to determine the permanent sources of capital used by the firm. Then, each source’s cost of capital is calculated at market values, weighted, and summed to arrive at WACC 6 Permanent sources of capital r Include all classes of equity r Include longterm debt r Exclude seasonal shortterm debt and accounts payable (these are working capital) r Exclude deferred taxes. 7 WACC r Aftertax WACC is summarised by the equation… ( ) ( ) 1 e d c E D W A C C r r T V V = × + × ×...
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 Three '08
 margretfinch
 Weighted average cost of capital, WACC Example

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