1. Weighted Average Cost of Capital The market value of the firm is the present value of the cash flows generated by the firm’s assets: The cash flows generated by the firm’s assets are divided among the investors who pay for the assets. If these investors include only debt and equity holders, the market value of the firm can be expressed as: PV firm = PV debt + PV Stock

2. Weighted Average Cost of Capital How is the discount rate, r, determined? Like the cash flows generated by the firm’s assets, the discount rate used to express those cash flows in present dollars is also influenced by claims of both debt and equity holders. The discount rate most commonly used is a weighted average of the returns required by debt and equity holders for the risk that they bear when they provide funds for the firm’s use.

3. Weighted Average Cost of Capital The weighted average cost of capital can be expressed as where –E is the market value of equity, or PV stock –D is the market value of debt, or PV debt –V is the market value of the firm, or PV firm –R E is the cost of equity or the return equity holders require now given the risk they are exposed to by buying equity in the firm. –R D is the cost of debt or the return debt holders require now given the risk they are exposed to by buying the debt of the firm. –T c is the corporate tax rate on the next dollar of taxable income.

4. Weighted Average Cost of Capital Numerical Example: Suppose a firm has $10,000,000 in debt on its balance sheet with 10 years remaining until maturity. The debt was originally issued 5 years ago. The coupon rate is 10% and the current yield is 11.27%. Interest is paid semi-annually. What is the market value of the debt today? What is the cost of new debt with this level of risk? If the firm wanted to issue this debt today at par value, what interest rate would the firm have to offer?

5. Weighted Average Cost of Capital Numerical Example (Continued): Suppose the firm also has 500,000 shares of common stock, selling at $100 per share. The book value per share is $75 per share. The most recent dividend on the common stock was $8.00 per share and dividends are expected to grow at a rate of 6% annually forever. –What is the cost of equity for this firm? –Is this rate reasonable? Why or why not? –Suppose the risk-free rate is 6%, and the market risk premium is 7%, what is the implied  for this firm’s stock?

6. Weighted Average Cost of Capital Numerical Example (Continued): If the firm’s marginal tax rate is 40%, what is the firm’s WACC?

7. Weighted Average Cost of Capital Numerical Example (Continued): Suppose now the firm is evaluating a new project by use of the NPV criterion. Under what circumstances can the new project be evaluated with the same WACC as existing assets? The two conditions are that 1. The new assets have the same risk as existing assets, and 2. The new assets will be financed with the same market value mix of debt and equity that the existing assets are financed with. What happens if we use the firm’s WACC when these conditions are not met?

8. Weighted Average Cost of Capital