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186
Business Finance (ACC501)
Lesson 36
Review of the Previous Lecture
•
Cost of Capital
–
Cost of Equity
–
Cost of Debt
–
Cost of Preferred Stock
•
Capital Structure Weights
–
The Tax Effect
Weighted Average Cost of Capital
•
To calculate the firm’s overall cost of capital, we multiply the capital structures with
the associated costs and add up the pieces. The result is called the Weighted
Average Cost of Capital (WACC)
WACC = (E/V) x R
E
+ (D/V) x R
D
x (1 – T
C
)
•
The WACC is the overall return the firm must earn on its existing assets to maintain
the value of the stock.
•
It is also the required return on any investments by the firm that have the same risks
as exiting operations. So for evaluating the cash flows a proposed expansion project,
this is the discount rate to be used.
•
For the firm using preferred stocks in its capital structure, the WACC would be:
WACC = (E/V) x R
E
+ (P/V) x R
P
+ (D/V) x R
D
x (1 – T
C
)
•
Suppose a company wants to renovate its warehouse distribution system. The plan
will cost $50 million and is expected to save $12 million per year after the taxes over
next six years.
•
The company has a target debtequity ratio of 1/3 (i.e. E/V is 0.75 and D/V is 0.25).
•
The company has a cost of debt of 10% and a cost of equity of 20%.
•
Assuming a tax rate of 34%, should the company go for the project?
•
The Weighted Average Cost of Capital is:
WACC = (E/V) x R
E
+ (D/V) x R
D
x (1 – T
C
)
= .75 x 20% + .25 x 10% x (1 – .34)
= 16.65%
•
Now the NPV will be:
12
12
NPV = $50 +  + …… + 
(1 + WACC)
1
(1 + WACC)
6
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This note was uploaded on 08/04/2011 for the course ACCT 501 taught by Professor Na during the Spring '11 term at Virtual University of Pakistan.
 Spring '11
 NA

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