Weighted Average Cost of Capital

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# Weighted Average Cost of Capital - PowerPoint PPT Presentation

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 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
• Think waaaaaaaaaaaay back…what are the sources of financing?
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.
• We need some sort of weighting!
• (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?
WACC
• WACC = (weight of equity) * R equity + (1-weight of equity) * (1-Tax rate)*R debt
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
• 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
• 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?