Weighted Average Cost of Capital

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Weighted Average Cost of Capital (WACC)

• This lecture answers the following questions: - What is the “opportunity” cost of funds for a firm, and thus the firm’s discount rate used in NPV calculations? - What is a firm’s Asset Beta & how do we lever Asset Betas and unlever Equity Betas? - Link to previous lectures - No longer use a “given” discount rate. We will calculate the correct discount rate for our NPV calculations. WACC - 1 2

1.0 The Cost of Capital: Some Preliminaries

• A. Required (rate of) Return versus Cost of Capital • Cost of capital - required return - appropriate discount rate all denote the same opportunity cost of using capital in one way as opposed to an alternative investment in the financial market having the same systematic risk. – required return: is from an investor's point of view – cost of capital: is the same return from the firm's point of view – appropriate discount rate: is the same return yet again to be used in a present value calculation

WACC - 2

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B. Required (rate of) Return

• COMBINING BOTH INVESTORS’ AND FIRMS’ PERSPECTIVES:

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A FIRMS COST OF CAPITAL OR DISCOUNT RATE IS GIVEN BY INVESTORS REQUIRED RATE OF RETURN.

• RETURN TO INVESTMENT DECISION!! • NPV of a project is dependent on: • (1) EXPECTED CASH FLOWS • (2) RISK WACC - 3 4

3 Determinants of Required (Rate of) Return

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What are investors’ concerned with? (and thus firms should also be concerned with.)

(1.) Real or inflation-adjusted rate of interest to compensate for the TIME VALUE OF MONEY. (2.) An inflation premium - equal to expected inflation. (3.) A Premium for systematic risk. (4.) Amount of systematic risk (β) WACC - 4 5

C.

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Rates of Return are Set in the Market

ON THE BASIS OF AN INTERACTION OF:

(1) VOLUME AND RISK-EXPECTED RATE OF RETURN OF PRODUCTIVE INVESTMENTS IN THE ECONOMY - DEMAND FOR CAPITAL. (2) SUPPLY OF CAPITAL AVAILABLE TO TAKE INTO...

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