20.2: The Cost of Capital

Question 1

What is the Weighted Average Cost of Capital (WACC)?

Answer 1

The Weighted Average Cost of Capital (WACC) is an estimate of a firm’s average cost of capital per $1 of financing, reflecting the required rate of return for all investors.

Question 2

How is the Weighted Average Cost of Capital (WACC) calculated?

Answer 2

WACC = (k_e * S/V) + (k_d * (1 - T) * D/V) + (k_p * P/V)

Where:
- k_e = Cost of equity
- S = Market value of equity
- V = Total market value (equity + debt + preferred shares)
- k_d = Cost of debt
- T = Corporate tax rate
- D = Market value of debt
- k_p = Cost of preferred shares
- P = Market value of preferred shares

Question 3

What does Total Enterprise Value (V) represent?

Answer 3

Total Enterprise Value (V) represents the market value of a firm’s invested capital, including all interest-bearing debt plus equity.

Question 4

How is the cost of equity (k_e) determined using enterprise value?

Answer 4

k_e = (ROI * IC) / V

Where:
- ROI = Return on investment
- IC = Invested capital
- V = Total enterprise value

Question 5

What are the steps involved in estimating a firm’s WACC?

Answer 5

1. Estimate market values for the firm’s sources of capital.
2. Estimate the current required rates of return for these sources.
3. Weight the costs of all sources based on their proportion of the firm’s total market value.

Question 6

Why is WACC important for a firm?

Answer 6

WACC is crucial because it reflects the minimum return a company must earn on its existing assets to satisfy its investors, guiding investment decisions and valuation.

Question 7

How can you estimate the market value of common equity?

Answer 7

Market value of common equity = Current share price * Number of shares outstanding

Question 8

How is the market value of preferred shares calculated?

Answer 8

Market value of preferred shares = (Dividend per preferred share / Required return on preferred shares) * Number of preferred shares

Question 9

What factors influence the market value of a firm’s debt?

Answer 9

The market value of a firm’s debt depends on current interest rates, the coupon rate, and time to maturity.

If debt is not publicly traded, book values may be used.

Question 10

What are some practical uses of WACC for managers?

Answer 10

Managers use WACC to evaluate investment projects, set financial policies, and determine if a firm’s existing projects are providing adequate returns.

Question 11

How does a change in corporate tax rates affect WACC?

Answer 11

An increase in corporate tax rates typically reduces the WACC because interest on debt is tax-deductible, reducing the after-tax cost of debt.

Question 12

Why is the weighted average cost of capital (WACC) so important?

Answer 12

WACC is critical as it represents the average rate of return required by all of a firm’s investors, guiding investment and financing decisions.

Question 13

How can we estimate the market value of common equity, preferred equity, and long-term debt?

Answer 13

• Common Equity: Market value = Share price * Number of shares
• Preferred Equity: Market value = (Dividend per share / Required return) * Number of shares
• Long-Term Debt: Use bond valuation techniques or book value if interest rates haven’t changed significantly.