The Weighted Average Cost of Capital

1
The Weighted Average Cost of Capital
2
Cash Flow

• Standard measure of cash flow
• (Rev OpCost)(1-tc) tcDep - ?NWC Capex
• OCF Ignore for now

3
Equity Cash Flow

• Alternatively, cash flow to equityholders
• (Rev OpCost RBB)(1-tc) tcDep
• (Rev OpCost)(1-tc) tcDep RBB(1-tc)
• OCF RB(1-tc)B

4
Equity Market Value

• Mkt Value Bal. Sheet
• B
• A
• __ S
• V V

• To calculate value of S
• Discount cash flow to
• equityholders at cost of equity, RS

5
Calculating Market Value
6
Calculating Market Value (cont.)

• Conclusion To estimate total market value,
  discount OCF at weighted ave. cost of capital

7
Weighted Ave. Cost of Capital (WACC)

• Use market value weights
• Use after-tax cost of debt
• Discount OCF (financing mix is captured in the
  discount rate)

8
Estimating Cost of Debt

• Use current bond yield, not the coupon rate on
  already outstanding debt
• We are trying to estimate the required return on
  newly-issued securities

9
Estimating Cost of Equity

• Two possibilities for estimating RS
• Capital Asset Pricing Model (CAPM)
• Dividend Discount Model (DDM)

10
Potential Pitfalls

• CAPM
• Beta should reflect business risk and financing
  characteristics of project (not the firm that
  undertakes it)
• What debt ratio can the project support?
• DDM
• Watch out for growth rate estimate

11
Determining Project Cost of Capital

• Stand alone principle value projects as if they
  were separate subsidiaries with their own capital
  structures
• What does the project contribute to companys
  systematic risk?
• Business risk
• Financial risk
• What does the project contribute to companys
  debt capacity?

12
Inappropriate Use of Firm WACC When Project
Risks Differ (Fig. 12.7)

• Expected Return
• SML
• B
• RWACC 15
• A
• RF 7
• 0.6 1 1.2 Beta
• Firm Beta