Lecture 6 - WACC Flashcards
What is the WACC formula?
rD(1-Tc)D/V+rE(E/V)
What are all of the variables in the WACC formula based on?
Current characteristics of the firm
Which kinds of projects does WACC give the correct discount for?
Correct discount rate for the AVERAGE PROJECT:
1) Business risk same as the average of the firms existing assets
2) Project will be financed to maintain the firms CURRENT market value debt ratio
What is the formula for the expected return on equity? When will a project NPV be 0?
Expected equity income/ equity value
When the cost of equity is equal to the required return on equity
When will the WACC need to be modified?
The project has different business risks to the firm , material change in the firms debt ratio
When will the WACC be approximately correct?
When the firm does not adjust its borrowing to maintain a constant debt ratio over time (but do not need to worry about small or temporary fluctuations in the debt ratio that do not change the firm’s long term financing policy)
What are the 3 steps to adjust WACC when debt ratios differ?
1) Unilever the WACC (get rid of tax) to get (r= Company cost of capital)
2) Estimate the cost of debt (Rd) and then determine the cost of equity Re= r+(r-Rd)*D/E
3) Re-calculate the WACC at the new financing weights
How can we use WACC to value an entire business?
Treat the business as one big project- discount the free cash flows including the free cash flows from the terminal year
What is the free cash flow formula?
FCF= Profit after tax + depreciation - investment in fixed assets - investment in working capital
Do we include the cost of financing when valuing businesses?
How do we calculate the terminal vale?
- No- do not deduct interest and calculate taxes as if the company were all equity financed.
- Forecast each year’s FCF out to an arbitrary medium-term horizon value and add terminal value
How do we calculate the firm value of equity?
Discount FCF = value of firm … then deduct the value of debt to get the value of equity
What are the three steps in calculating the WACC?
1) Determine the market value of all securities
2) Calculate the cost of each security
3) Calculate the WACC
Which types of securities are included?
All equity securities - and all financial liabilities where interest must be paid (including finance lease and hire purchase liability)
1) Why is AP and other accounting liabilities excluded from the analysis?
2) Why are deferred taxes and other accounting liabilities excluded?
3) Are issue costs included in the share price?
4) Why are other equity accounts (i.e. capital, reserves & RE) excluded?
1) Would have netted our assets they are held against
2) Not a security held by investors
3) Nope - do not net - we don’t care how much the company actually receives - we just care about the market price
4) Reflected implicitly in the share price
How do we calculate the market value of the following?
1) Bank overdraft
2) Bank mortgage loan
3) Bonds
4) Preference shares
5) Ordinary shares
1) Overdraft: MV= BV
2) Mortgage
a) Determine annual cost = balance/ [PVAF]
b) Present value of cost= EAC*[PVAF]
3) Bonds: Coupon * [PVAF} + FC (1+r)^-n
4) Preference shares: number of shares * price per share
5) Ordinary shares * price per share (in market share price- don’t net
