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Topic 6 Weighted Average Cost of Capital (WACC)

Topic 6 Weighted Average Cost of Capital (WACC) - Topic 6...

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Topic 6 Cost of Capital
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2 How to Work out the Discount Rate the Firm should use in Undertaking a NPV Analysis? ANSWER Use the firm’s rate of return ie the return the firm earns on its assets/ “capital” . Quick rough guide as to whether an investment is viable -never invest in anything that does not at least cover the cost of your money (capital)
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What Is Capital? Firm’s stock of funds Represented in balance sheet as either: real assets of the firm Or financial assets of the firm Capital can be viewed as one of the inputs or factors of production in the firms operations in the same way as salaries and wages, raw materials, rent, fuel and power Just like other inputs, capital has a cost and must be paid for
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Cost Of Capital Cost of funds supplied to finance firm Compensation for providers of capital Opportunity cost foregone by providers for tying up capital in assets of firm Rate of return the firm must generate from investments to compensate suppliers of capital
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Cost of Capital The cost of capital is determined by the use to which it is put: Capital is used to finance investments These investments in turn generate the cash flows used to service the capital The risk of the cash flows used to service the capital will be determined by the nature of the investments The higher the risk of the investments, the higher will be the return required by the suppliers of the capital Therefore it is the nature of the investments that determines the cost of capital
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Weighted Average Cost Of Capital As the company draws funds from several sources the firm’s cost of capital is the sum of the weighted average cost of each source of capital, WACC . WACC is one cost representative of the cost of each source of finance where each cost is weighted by its relative importance to the total r r = = Σ Σ r r i     w w i where: where: r r = = the weighted average cost of capital r i = the cost if the ith source funds W i = the weighting of the ith source of funds in the firm’s capital structure
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Cost of Capital Before Tax Assuming that there are only two sources of Capital, these being Debt and Equity The Cost of Capital Before Tax is cost of debt + cost of equity + cost of government Rate of return the firm needs to earn on its assets/projects in order to compensate Debt holders, Equity holders and the Government
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8 Cost of Capital Before Tax Total Revenue less Operating costs equals Net Operating Income less Interest ( cost of debt ) less Tax ( cost of government ) equals Net Income ( cost of equity (dividends))
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Assuming Two Sources Of Finance and No Tax r r e = the cost of equity capital = the cost of equity capital E / V E / V = the proportion of equity in the capital structure = the proportion of equity in the capital structure r r d = the cost of debt capital = the cost of debt capital D / V D / V = the proportion of debt in the capital structure = the proportion of debt in the capital structure D D = market value of debt = market value of debt E E = market value of equity = market value of equity r = r r = r e E/V + r E/V + r d d D/V D/V
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