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ECON*2560- THEORY OF FINANCE CHAPTER 12: THE WEIGHTED AVERAGE COST OF CAPITAL AND COMPANY VALUATION - learned that CAPM model and how to use it to estimate the expected rate of return on a company’s stock o the firm however, the firm is not financed wholly by common stock ( generally), they receive financing through the selling of other securities company’s might also receive finance through other securities such as; including the common stock, bonds, and often preferred stock or other securities all of these have different risks and therefore different rates of return that are associated with them in any circumstance, the company cost of capital is no longer the same as the expected return on the common stock o it is dependent on the expected return from all the securities that the company has issued o it is also depended on taxes , as interest payments are made by corporation are a tax- deductible expense - therefore, the company cost of capital is usually calculated as a weighted average of the after tax interest cost of debt financing and the ‘ cost of equity’ ; the expected rate of return on the firm’s common stock o where, the weights are the fractions of debt and equity in the firm’s capital structure. - The weighted average cost of capital is commonly referred to as WACC - Managers use WACC to evaluate average-risk capital investment projects ‘average risk’ means that the project’s risk matches the risk of the firm’s existing assets and operations In our further readings, we will determine how WACC is calculated in practice 12.1 GEOTHERMAL’S COST OF CAPITAL - Recall: cost of capital is / will be used interchangeably to its’ expected rate of return - Calculating the cost of capital depends on the expected rates of return on a company’s assets o The rates of return are dependent on the assets risk Let’s suppose a company is only financed through issuing stocks- no debt; - Then, owning a stock means owning the assets - The expected return demanded by investors in the stock must also be the cost of capital for the assets o Recall, cost of capital: The required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity. - The identities are associated with companies that are financing using no- debt: Value of business = value of stock Risk of business = risk of stock Rate of return on business= rate of return on stock Investor’s required return from business= investors’ required return from stock
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- However, it is in most cases that companies acquire financing from other sources (ex. Borrowing from a bank) o Furthermore, it’s shareholders did not have encumbered ownership of the company’s assets. o
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