CHAPTER 12 question 2

Wacc

(E/V) = % of common equity in capital structure (P/V) = % of preferred stock in capital structure (D/V) = % of debt in capital structure RE = firm's cost of equity RP = firm's cost of preferred stock RD = firm's cost of debt TC = firm's corporate tax rate

Wacc

WACC = (E/V) X RE + (P/V) X RP + (D/V) x RD X (1- TC) E: equity (mv of firm' V: Value (combined market value of debt and equity) RE: Return on Equity D: debt (market val of firm's debt) RD: TC: Corporate tax rate The last 2 parts times each other are the after-tax rate.

It is inappropriate to use WACC as the discount rate when:

o Because WACC of a firm, reflects the risk and the target capital structure of the firm's existing assets as a whole, WACC is appropriate discount rate ONLY if the proposed investment is a replica of the firm's existing operating activities. - Must be the same "risk class" as the firm's. o So it is INAPPROPRIATE to use WACC when the proposed investment has risks that are substantially different from those of the overall firm.

Alternatives to using WACC:

o Pure play approach: using a WACC that is unique to a particular project, based on companies in similar lines of business. o Subjective approach: involves making subjective adjustments to the overall WACC.

2) Weighted Average Cost of Capital:

the weighted average of the cost of equity and the after-tax cost of debt* WACC is the overall return the firm must earn on its existing assets to maintain the value of its stock. Also the required return on any investments by the firm that have essentially the same risks as existing operations... WACC is the discount rate we would use, if we were calculating the cash flows from a proposed expansion of our existing operations. reflects the risk of an average project undertaken by the firm