Chapter 13 WACC

Question 1

Capital structure

Answer 1

The mix of long term debt and equity financing

Question 2

Average risk investments (all equity financed firm wants to expand what discount rate should we use in the NPV analysis ?)

Answer 2

The excepted rate of return that outside investors would demand in order to invest money in the project

This will equal the expected ROR of the urns real assets - the firms cost of capital

Company cost of capital - opportunity cost of capital for the 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 3

An all equity financed firm’s cost f capital

Answer 3

• Value of firm= value of stock
• Risk of firm = Risk of stock
• ROR of firm’s assets= ROR of firm’s stock
• Investors’ required ROR from firm = investors’ required ROR from stock

Firms cost of capital is equal to ROR of the firms stock

Question 4

Cost of capital If the firm is not all equity financed ?

Answer 4

• Value of the firm = value of portfolio of firm’s debt and equity securities
• risk of firm = risks of portfolio
• ROR of firm’s assets = ROR of portfolio
• Investors’ required ROR from firm = Investors’ required ROR from portfolio

The firm’s cost of capital is equal to the market value weighted ROR of the portfolio

Question 5

Calculating WACC

Answer 5

The company cost of capital is a weighted average of the returns demanded by debt and equity investors.

The weighted average is the expected rate of return investors would demand on a portfolio of all the firms outstanding securities

Step 1 : calculate the value of each security as a proportion of the firms market value

Step 2: determine the required rate of return on each security

Step 3: calculate a weighted average after tax return on the debt and the return on the equity

Question 6

Weighted average cost of capital (WACC)

Answer 6

Expected rate of return on a portfolio of the all the firm’s securities,adjusted for tax savings due to interest payments

Equation (two sources of finance )

[D/V X (1-Tc)rdebt] + (E/V X R equity)

V= total market value 
D= market value of outstanding debt 
E= market value of equity 
Rdebt= cost of debt 
Requiry= cost of equity 
Tc= corporate tax rate 
D/V= percentage of financing that is debt 
E/V = percentage of financing that is equity

Question 7

Calculate WACC with three or more sources of finance

Answer 7

[D/V X (1-Tc)rdebt] +(P/V x Rpreffered) + (E/V X R equity)

Just add in a calculation for the other type of severity here it is preferred stock (P)

Equity can be referred to as common stock

Question 8

Market weights or book weights

Answer 8

The cost of capital must be based on what investors are actually willing to pay for the companies outstanding securities

Question 9

What happens when the corporate tax rate is not zero

Answer 9

Weighted average costs of capital is the right discount rate for average risk capital investments

The weighted average cost of capital is the return the company needs to earn after tax in order to satisfy all its security holders

If the firm increases its debts ratio, both debt and equity will become riskier. The debt holders and equity holders require a higher return to compensate for increased risk

Question 10

How changing capital structure affects expected returns

Answer 10

Where corporate tax rate is 0

If there are no corporate taxes, the change in capital structure does not affect the total cash that the firm pays out to its security holders, and does not affect the risk of those cash flows

WACC unaffected

Increasing the debt makes it riskier meaning returns are higher and balances out

The more debt added the more expensive the cost of debt becomes

Question 11

IRR relevance

Answer 11

If the IRR is higher than the WACC then the project should be accepted