WACC and CAPM PDF

Weighted Average Cost of Capital A firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of capital across all sources, including common shares, preferred shares, and debt. The cost of each type of capital is weighted by its percentage...

Weighted Average Cost of Capital A firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of capital across all sources, including common shares, preferred shares, and debt. The cost of each type of capital is weighted by its percentage of total capital and they are added The following steps are involved for calculating the form’s WACC: Calculate the cost of specific sources of funds. Multiply the cost of each source by its proportion in the capital structure. Add the weighted component costs to get the WACC. In financial decision making the cost of capital should be calculated after tax basis.  MCQ The overall (weighted average) cost of capital is composed of a weighted average of __________. A.the cost of common equity and the cost of debt B.the cost of common equity and the cost of preferred stock C.the cost of preferred stock and the cost of debt  Answer D. the cost of common equity, the cost of preferred stock, and the cost of debt Formula for WACC  Contd…. In a general form, the formula for calculating WAC can be written as follows: where k1, k2, … are component costs and w1, w2, … weights of various types of capital, employed by the company.  MCQ The weighted average cost of capital for a firm is the: a.Discount rate which the firm should apply to all of the projects it undertakes. b.Rate of return a firm must earn on its existing assets to maintain the current value of its stock. c.Coupon rate the firm should expect to pay on its next bond issue. B. Rate of return a firm must earn on its existing assets to maintain the current value of its stock.  Illustration The following information is available from the balance sheet of the company: Equity share capital (2,00,000 shares) ₹ 40,00,000 11.5% Preference share ₹ 10,00,000 10% Debenture ₹ 30,00,000 The equity share of the company sells for ₹ 20. It is expected that the company will pay next year a dividend of ₹ 2 per equity share, which is expected to grow at 5% p.a. forever. Assume a 35% corporate tax rate. Compute weighted average cost of capital (WACC) of the company based on the existing capital Solution Contd…… Contd….. Why do managers prefer the book value weights for calculating WACC? 1)Firms in practice set their target capital structure in terms of book values. 2)The book value information can be easily derived from the published sources. 3)The book value debt equity ratios are analyzed by investors to evaluate the risk of the firms in the practice.  Contd….. Market value weights are theoretically superior to book value weights. They reflect economic values and are not influenced by accounting policies. They are also consistent with market determined component costs.  Contd…… The difficulty in using market value weights is that the market prices of securities fluctuate widely and frequently. A market value based target capital structure means that the amounts of debt and equity are continuously adjusted as the value of the firm changes. Cost of Equity & The CAPM (Capital Asset Pricing Model)  MCQ If the CAPM is used to estimate the cost of equity capital, the expected excess market return is equal to the: a.Return on the stock minus the risk-free rate. b.Difference between the return on the market and the risk-free rate. c.Beta times the market risk premium. b. Difference between the return on the market and the risk-free rate.  Illustration The risk-free rate of return of the Purple Widget Company is 5%, the return on the Dow Jones Industrials is 12%, and the company’s beta is 1.5. The cost of equity is?  MCQ To compute the required rate of return for equity in a company using the CAPM, it is necessary to know all of the following EXCEPT: A.the risk-free rate. B.the beta for the firm. C.the earnings for the next time period.  Answer C. the earnings for the next time period.