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

(1 - T_sub_c) × r_sub_debt

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

(1 - tax rate) × pretax cost, (1 - T_sub_c) × r_sub_debt

After-tax cost of debt = ___1___ = ___2___

(1 - tax rate) × pretax cost

After-tax cost of debt = _____ = (1 - T_sub_c) × r_sub_debt

free cash flow (FCF)

Cash flow available for distribution to investors after firm pays for new investments or additions to working capital.

weighted average of debt and equity returns, total income / value of investment, ((D × r_sub_debt) + (E × r_sub_equity)) / V, (D / V × r_sub_debt) + (E / V × r_sub_equity)

Company cost of capital (r_sub_assets) = ___1___ = ___2___ = ___3___ = ___4___

weighted average of debt and equity returns

Company cost of capital (r_sub_assets) = _____ = total income / value of investment = ((D × r_sub_debt) + (E × r_sub_equity)) / V = (D / V × r_sub_debt) + (E / V × r_sub_equity)

total income / value of investment

Company cost of capital (r_sub_assets) = weighted average of debt and equity returns = _____ = ((D × r_sub_debt) + (E × r_sub_equity)) / V = (D / V × r_sub_debt) + (E / V × r_sub_equity)

(D / V × r_sub_debt) + (E / V × r_sub_equity)

Company cost of capital (r_sub_assets) = weighted average of debt and equity returns = total income / value of investment = ((D × r_sub_debt) + (E × r_sub_equity)) / V = _____

((D × r_sub_debt) + (E × r_sub_equity)) / V

Company cost of capital (r_sub_assets) = weighted average of debt and equity returns = total income / value of investment = _____ = (D / V × r_sub_debt) + (E / V × r_sub_equity)

r_sub_f + β(r_sub_m - r_sub_f)

Cost of equity (r_sub_equity) (CAPM) = _____

weighted-average cost of capital (WACC)

Expected rate of return on a portfolio of all of the firm's securities, adjusted for tax savings due to interest payments. _____ is the correct discount rate for projects that have similar risks to the company's existing business... If a project has zero NPV when the expected cash flows are discounted at the _____, then the project's cash flows are just sufficient to give debtholders and shareholders the returns they require... We have shown that when there are no corporate taxes, the _____ is unaffected by a change in capital structure. Unfortunately, taxes can complicate the picture. For the moment, just remember: -The _____ is the right discount rate for average risk capital investments. -The _____ is the return the company needs to earn after tax in order to satisfy all its security holders. -If the firm increases its debt ratio, both the debt and the equity will become riskier. The debtholders and equityholders require a higher return to compensate for increased risk... We have explained the formula for calculating the _____... But where do you get the data? Financial managers usually start with the company's accounts, which show the book value of debt and equity, whereas the _____ formula calls for their market values. A little work and a dash of judgement are needed to go from one to the other.

risk-free interest rate + (stock's beta × expected market risk premium)

Expected return on stock = _____

relative

Most of us, lacking perfect pitch, need a well-defined reference point, like middle C, before we can sing on key. But anyone who can carry a tune gets _____ pitches right. Businesspeople have good intuition about _____ risks, at least in industries they are used to, but not about absolute risk or required rates of return. Therefore, they set a company- or industrywide cost of capital as a benchmark.

company cost of capital

Opportunity cost of capital for investment in the firm as a whole. The _____ is the appropriate discount rate for an average-risk investment project undertaken by the firm... Think again what the _____ is, and what it is used for. We define it as the opportunity cost of capital for the firm's existing assets; we use it to value new assets that have the same risk as the old ones... The _____ is a weighted average of the returns demands by debt and equity investors. The weighted average is the expected rate of return investors would demand on a portfolio of all the firm's outstanding securities... 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.

dividend / r_sub_preferred

Price of preferred (stock) = _____

DIV₁ / (r_sub_equity - g)

Remember the formula: If dividends are expected to grow indefinitely at a constant rate g, then the price of the stock is equal to P₀ (Dividend Discount Model) = _____ where P₀ is the current stock price, DIV₁ is the forecast dividend at the end of the year, and r_sub_equity is the expected return from the stock.

capital structure

The mix of long-term debt and equity financing.

less

The operating cash flow _____ investment expenditures is the amount of cash that the business can pay out to investors after paying for all investments necessary for growth (FCF).

PV_sub_H / (1 + WACC)^H

The value of the deconstruction operation is equal to the discounted value of the free cash flows (FCFs) out to a horizon year plus the forecast value of the business at the horizon, also discounted back to the present. That is, PV = FCF₁ / (1 + WACC) + FCF₂ / (1 + WACC)² + ... + FCF_sub_H / (1 + WACC)^H + _____, where FCF₁ / (1 + WACC) + FCF₂ / (1 + WACC)² + ... + FCF_sub_H / (1 + WACC)^H = PV(free cash flows) and _____ = PV(horizon value)

FCF₁ / (1 + WACC) + FCF₂ / (1 + WACC)² + ... + FCF_sub_H / (1 + WACC)^H, PV_sub_H / (1 + WACC)^H

The value of the deconstruction operation is equal to the discounted value of the free cash flows (FCFs) out to a horizon year plus the forecast value of the business at the horizon, also discounted back to the present. That is, PV = ___1___ + ___2___, where ___1___ = PV(free cash flows) and ___2___ = PV(horizon value)

FCF₁ / (1 + WACC) + FCF₂ / (1 + WACC)² + ... + FCF_sub_H / (1 + WACC)^H

The value of the deconstruction operation is equal to the discounted value of the free cash flows (FCFs) out to a horizon year plus the forecast value of the business at the horizon, also discounted back to the present. That is, PV = _____ + PV_sub_H / (1 + WACC)^H, where _____ = PV(free cash flows) and PV_sub_H / (1 + WACC)^H = PV(horizon value)

explicit, implicit

There are actually two costs of debt finance. The ___1___ cost of debt is the rate of interest that bondholders demand. But there is also an ___2___ cost because borrowing increases the required return to equity.

explicit

There are actually two costs of debt finance. The _____ cost of debt is the rate of interest that bondholders demand. But there is also an implicit cost because borrowing increases the required return to equity.

implicit

There are actually two costs of debt finance. The explicit cost of debt is the rate of interest that bondholders demand. But there is also an _____ cost because borrowing increases the required return to equity.

(D / V × (1 - T_sub_c) r_sub_debt) + (E / V × r_sub_equity) + (P / V × r_sub_preferred) + (E / V × r_sub_equity)

WACC (for a firm with preffered stock as well as common stock and bounds outstanding) = _____

(D / V × (1 - T_sub_c) r_sub_debt) + (E / V × r_sub_equity)

WACC (general formula) = _____

after, before

When you calculate a project's NPV, you need to discount the cash flows ___1___ tax assuming that the project is wholly equity-financed... Sometimes, you may encounter companies that forecast cash flows ___2___ tax and then try to compensate for this by using a higher discount rate. It doesn't work; there is no simple adjustment to the discount rate that will allow you to discount pretax cash flows.

after

When you calculate a project's NPV, you need to discount the cash flows _____ tax assuming that the project is wholly equity-financed... Sometimes, you may encounter companies that forecast cash flows before tax and then try to compensate for this by using a higher discount rate. It doesn't work; there is no simple adjustment to the discount rate that will allow you to discount pretax cash flows.

before

When you calculate a project's NPV, you need to discount the cash flows after tax assuming that the project is wholly equity-financed... Sometimes, you may encounter companies that forecast cash flows _____ tax and then try to compensate for this by using a higher discount rate. It doesn't work; there is no simple adjustment to the discount rate that will allow you to discount pretax cash flows.

DIV₁ / P₀ + g

r_sub_equity (Dividend Discount Model) = _____... Remember that the constant-growth formula will get you into trouble if you apply it to firms with very high current rates of growth. Such growth cannot be sustained indefinitely.

dividend / price of preferred

r_sub_preferred = _____