WACC and Company Valuation Flashcards
Cost of capital and risk
Investors, who invest in equity, debt, or preferred stock, would
require different cost of capital from the three securities
because they are facing different levels of risk
What are the three types of securities?
Common stock or equity: Ownership shares in a publicly held
corporation.
* Corporate bond or debt: Security that obligates the company
to make specified payments to the bondholder.
* Preferred stock: Stock that takes priority over common stock
in regard to dividends.
What is capital structure?
Capital structure refers to the way a corporation finances its
assets through some combination of equity, debt, or hybrid
securities.
E = market value of equity
D = market value of debt
V = total markt value of the firm
What discount rate should we use in the NPV analysis?
The expected rate of return (RoR) that outside investors would demand in order to invest money in the project.
This will equal the expected RoR of the firm’s real
assets -> the firm’s cost of capital
A firm’s cost of capital for an all equity-financed firm
- Value of firm = Value of stock
- Risk of firm = Risk of stock
- RoR of firm’s assets = RoR of firm’s stock
- Investors’ required RoR from firm = Investors’
required RoR from stock
The firm’s cost of capital is equal to the RoR of the
firm’s stock
A firm’s cost of capital if the firm is not all equity-financed
Value of firm = Value of portfolio of firm’s debt
and equity securities
- Risk of firm = Risk of portfolio
- RoR of firm’s assets = RoR of portfolio
- Investors’ required RoR from firm = Investors’
required RoR from portfolio
The firm’s cost of capital is equal to the market
value weighted RoR of the portfolio
Formula for after tax cost of debt
(1-tax rate) x pre-tax cost
What is WACC?
The WACC is the expected rate of return on a
portfolio of all the firm’s securities, adjusted for
tax savings due to interest payments
The formula is
(D/V x (1-Tc) x r debt)) + (E/V x r equity)
Interpreting WACC
The WACC is the rate of return that the firm must
expect to earn on its average-risk investments in
order to provide the opportunity rate of return to
all its investors
Investment projects with higher or lower risk
than average business risk should be discounted
with rates above or below the WACC, respectively
What happens when you increase the debt ratio?
Increased interest rates demanded by debt
holders
– Increased RoR demanded by equity holders
- Increased WACC
How to value an entire firm?
Treat the firm as one big project and discount the firm’s free cash flows by the WACC.
What is FCF?
FCF is the amount of cash that the firm can pay out
to investors after paying for all investments
necessary for growth
FCF = Operating cash flow - Investment expenditures
What is horizon value formula?
Horizon value = FCF / r-g
What is CAPM?
The Capital Asset Pricing Model (CAPM) is the most
common approach for estimating the cost of equity
capital of a company i
What is CAPM formula?
ri = rf + Beta i (rm - rf)
