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**Unformatted text preview: **1 Chapter 13 The Weighted Average Cost of Capital and Company Valuation CAPM and the Capital Budgeting 2 Topics Covered Geothermal’s Cost of Capital Weighted Average Cost of Capital (WACC) Measuring Capital Structure Calculating Required Rates of Return Interpreting WACC Valuing Entire Businesses . 3 Cost of Capital Cost of Capital- The return the firm’s investors could expect to earn if they invested in securities with comparable degrees of risk. Capital Structure- The firm’s mix of long term financing and equity financing. 4 Cost of Capital Example- Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital? 100% $647 Assets Value Market 70% $453 Equity Value Market 30% $194 Debt Value Market 5 Cost of Capital If you invest in a stock, you require a an expected rate of return, or the cost of capital for your investment in the stock. If you invest in a bond, you require a an expected rate of return, or the cost of capital for the bond. Then, if you invest in a a portfolio of all the firm’s securities (debt and stock), what is the expected rate of return you require? The expected rate of return on a portfolio of all the firm’s securities is called the weighted average cost of capital (WACC). It is also called the expected return on the asset of the firm. 6 Cost of Capital securities equity and debt s firm’ the all of portfolio of value business of Value = portfolio on return retuired investors' business on return required s Investor' = portfolio of risk business of R isk = portfolio on return of rate business on return of Rate = Company cost of capital 7 Cost of Capital Example (Continued) 12.2% = (.7x14%) + (.3x8%) = Return Portfolio Interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2% (i.e. 8 % x .65). 11.4% = (.7x14%) + (.3x5.2%) = WACC 8 WACC Weighted Average Cost of Capital (WACC)- The expected rate of return on a portfolio of all the firm’s securities. Company cost of capital = Weighted average of debt and equity returns. 9 WACC If we use D , E, and V to denote the market values of debt, equity, and firm (asset), respectively, then V=D+E, and V ) r (E + ) r (D assets equity debt r × × = ( 29 ( 29 equity V E debt V D assets r r r × + × = s investment of value income total assets = r 10...

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