9WACC2 - A Closer Look at WACC 1 FinancingDecision...

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A Closer Look at WACC 1
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Financing Decision Maximize firm value through optimal capital structure Implement a capital structure with the optimal mix of equity and debt Issue the right kind of debt and equity securities to match assets 2
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More about WACC WACC is an estimate of the marginal cost of capital for the firm Cost of the next dollar of financing We now know more about capital structure and how it affects the WACC of a firm Capital structure affects the cost of equity and the beta of the firm’s equity Leverage also affects the cost of debt for the firm Let’s reapply these ideas to the capital budgeting topics we spoke about for the first half of the course 3
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Discounting Using WACC Using WACC to discount cash flows takes into account: All sources of financing The correct weights of all financing sources (market value weighted) The correct cost of each financing source, which is tied to the risk of the financing source Tax consequences of financing sources (interest tax shields) 4
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WACC Assumptions By using the WACC of the firm to discount the cash flows of a particular project, you are assuming: The project can support the same capital structure as the firm Same capacity to support debt The project has similar risk to the firm Toyota building auto manufacturing plant Microsoft beginning a software development project Kraft developing a new food product The capital structure and risk of the firm remains constant over the life of the project 5
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What if the assumptions are not met? What if the project doesn’t meet one of the required assumptions? Project has similar risk to the firm, but can’t support same capital structure as the firm Adjust the firm WACC to match the project capital structure Project risk differs from firm risk Find project-specific cost of capital Changing firm capital structure or risk Must use Adjusted Present Value technique Essentially, include project financing cash flows in your NPV calculation and discount at opportunity cost of capital Relatively straightforward extension of DCF method of capital budgeting 6
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1) Adjusting for Different Capital Structure Let’s assume for now that our project has similar risk to the firm Sometimes projects can’t support the same capital structure as the firm
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This note was uploaded on 09/22/2011 for the course FINANCE 117 taught by Professor Tingtingque during the Summer '11 term at University of Iowa.

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9WACC2 - A Closer Look at WACC 1 FinancingDecision...

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