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2_wacc_and_arbTAU - WEIGHTED AVERAGE COST OF CAPITAL and...

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1 WACC WEIGHTED AVERAGE COST OF CAPITAL and ARBITRAGE This lecture addresses two separate basic issues: - What is the “opportunity” cost of funds for a firm, that is the firm’s discount rate used in NPV calculations? - What is arbitrage and how can it be exploited?
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2 WACC The Cost of Capital: Preliminaries Required Return versus Cost of Capital Cost of capital = required return = discount rate All of these terms denote the opportunity cost of using capital to finance a project which equals the return on an investment of comparable risk in a financial asset required return: from an investor's point of view cost of capital: from the firm's point of view
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3 WACC Discount Rate Combining both investors’ and firms’ perspectives: A firm’s cost of capital is given by investors required rate of return, which in turn is the discount rate to use in NPV calculations The NPV of a project depends on: expected cash flows risk (reflected in the discount rate)
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4 WACC Determinants of Required Return What are investors and firms concerned with?
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