Week 10 Lecture CoC

Week 10 Lecture CoC - COSTOFCAPITAL Chapter20 TOPICSCOVERED...

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COST OF CAPITAL Chapter 20
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TOPICS COVERED Consistency After Tax WACC Tricks of the Trade Dangers in WACC Adjusted Present Value Financing Assumptions Adjusting WACC Effects of Imputation A General Model
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QUIZ The method to determine the net present value  for an all equity firm    A) Discounts the cash flows after tax by the levered  equity rate    B) Discounts the cash flows after tax by the WACC    C) Discounts the earnings after tax by the unlevered  equity rate    D) Discounts the cash flows after tax by the  unlevered equity rate 
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CONSISTENCY Consider a simple perpetuity: Many combinations of C and r* will give V. Also note that  The moral is simple: The discount rate r* has to  be defined consistently with C to get the correct  V. C in turn needs to be consistent with V Very simple, but a frequent source of error. * r C V = V C r = *
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WHICH CASH FLOW? We start by using the same cash flow as  we used in capital investment appraisal. The unlevered cash flow after corporate tax: Note that this cash flow is measured  before the deduction of interest and before  we account for the interest tax shield. It is the cash flow for an unlevered firm. This cash flow values the asset = working  capital + fixed assets = financial debt +  equity  C t (1-T c )
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ADJUSTING THE DISCOUNT RATE  OR THE CASH FLOW A major adjustment is for the debt tax shield There are two main ways to do this 1. Adjust the discount rate - the usual approach.
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QUIZ Discounting at the WACC assumes that debt is  rebalanced every period to maintain a constant  ratio of debt to market value of the firm.    A) True    B) False 
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AFTER TAX WACC If excluded from the cash flow, the tax benefit  from interest expense deductibility must be  included in the cost of capital.   This tax benefit reduces the effective cost of debt  by a factor of the marginal tax rate.  Under a classical tax system a simple adjustment  to the cost of debt is used.
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AFTER TAX WACC × + - = E D r V E V D r Tc WACC ) 1 ( Tax Adjusted Formula This formula can also be used under imputation BUT only if we make a special adjustment to the cash flow.
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QUIZ When calculating the WACC for a firm, you  should use the book values of debt and equity.    A) True    B) False  When discounting at the WACC, you assume that  the project supports the same fraction of debt to  value as the firm as a whole.    A) True    B) False 
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AFTER TAX WACC Example -  Geothermal Ltd. The firm has a marginal tax rate of 35%.  The 
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Week 10 Lecture CoC - COSTOFCAPITAL Chapter20 TOPICSCOVERED...

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