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Weighted Average Cost of Capital. Instructor: Williams. Weighted Average Cost of Capital . Also abbreviated “WACC” Don’t get thrown by the jargon! Remember! Cost of Debt Capital = Required Rate of Return on Debt Cost of Equity Capital = Required Rate of Return on Equity/Stock

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weighted average cost of capital1
Weighted Average Cost of Capital
  • Also abbreviated “WACC”
  • Don’t get thrown by the jargon!
  • Remember!
  • Cost of Debt Capital = Required Rate of Return on Debt
  • Cost of Equity Capital = Required Rate of Return on Equity/Stock
  • Think waaaaaaaaaaaay back…what are the sources of financing?
financing and waac
Financing and WAAC
  • Financing is with debt & equity.
  • If we know “r” for debt, and “r” for equity, what should be our “r” for capital budgeting?
  • Alternatively, we know our cost of debt and our cost of equity, what is our cost of CAPITAL?
it is just the weighted average of the two
It is just the weighted average of the two.
  • We need some sort of weighting!
  • What about this one?:
  • (weight of equity) * cost of equity+ (1-weight of equity) * cost of debt
  • Think back to day #1 => there is a tax break to debt.
  • So we have to discount debt by the tax rate.
  • How?
slide5
WACC
  • WACC = (weight of equity) * R equity + (1-weight of equity) * (1-Tax rate)*R debt
big assumption important
BIG assumption - Important
  • KNOW THIS!
  • In this class, we treat WACC for firm as WACC for capital budgeting project.
  • This is to keep problems simple.
  • THIS IS ONLY TRUE IF NEW PROJECT IS EXACTLY LIKE THE REST OF THE COMPANY!
  • Usually not true.
simple example
Simple Example
  • The CFO estimates that the cost of debt is 4% and the cost of equity is 11%. The market cap of the entire firm is $500 million, the market cap of equity is $300 million.
  • What is the cost of capital?
complicated example
Complicated Example
  • You are advising the CFO of Jupiter Motors. She wants to know her cost of capital. You observe the following information:
  • You have 1 million bonds outstanding. The bonds have a face value of $1000 and a coupon rate of 8%. The bonds are currently trading at $894.
  • Your stock’s beta is 1.2, the market return is 9% and the risk free rate is 3%. You have 2 million shares outstanding. Your shareholders expect dividend growth of 1% and you paid a dividend of $3 yesterday.
  • Your tax rate is 35%.
  • What is the cost of capital?