Chapter 13: The Weighted-Average Cost of Capital and Company Valuation

Question 1

What is the definition of Capital Structure?

Answer 1

The mix of long-term debt and equity financing.

Question 2

What is the distinction between calculating portfolio return and WACC?

Answer 2

Interest is tax deductible.
Ex. If Geothermal pays $1 of interest, taxable income is reduced by $1, and the firm’s tax bill drops by 21 cents (assuming 21% tax rate), the net cost becomes only 79 cents. So the after-tax cost of debt changes from 8% to .79*8% = 6.3%. So, WACC = (.3X6.3%) + (.7X14%)=11.7%

Question 3

What is the definition of company cost of capital?

Answer 3

Opportunity cost of capital for investment in the firm as a whole. The company cost of capital is the appropriate discount rate for an average-risk investment project undertaken by the firm.

Question 4

What is the expected return investors would demand on a portfolio of a firm’s outstanding securities?

Answer 4

The company cost of capital (aka the weighted average of the returns demanded by debt and equity investors).

Question 5

What is the formula for Company Cost of Capital?

Answer 5

Company Cost of Capital = Weighted Average of Debt and Equity Returns
OR
(D x r_debt) + (E x r_equity) ➗ value of investment

Question 6

Should Cost of Capital be based on market value or book value?

Answer 6

The cost of capital must be based on what investors are actually willing to pay for the company’s outstanding securities – that is, based on the securities’ market values.

Question 7

What is the formula for after-tax cost of debt?

Answer 7

After-tax cost of debt = (1 - tax rate) X pretax cost

e.g. (1 - .21) X 8% = 6.3%

Question 8

What is the definition of weighted-average cost of capital (WACC)?

Answer 8

Expected rate of return on a portfolio of all the firm’s securities, adjusted for tax tax savings due to interest payments. WACC is the correct discount rate for projects that have similar risks to the company’s existing business.

Question 9

What is the formula for WACC?

Answer 9

WACC = [D/V x (1-T_c)r_debt] + (E/V x r+equity)

Question 10

What are the three steps for calculating WACC?

Answer 10

1. Calculate capital structure using market value weights
2. Determine the required rate of return on each security.
3. Calculate a weighted average of the after-tax return on the debt and the return on the equity.