lecture 1 Understanding Weighted Average Cost of Capital and Adjusted Net Present Value

These flashcards cover key concepts related to the weighted average cost of capital and adjusted net present value, important for understanding financial risk and investment evaluations.

What is adjusted WACC?

A way to see how much a new project costs after including its risk.

What is Beta?

A number that shows how risky a company is compared to the whole market.

What is the difference between equity beta and asset beta?

Equity beta includes money risk, but asset beta only includes regular business risk.

How do you find cost of equity with dividends?

Cost = (D1 / P0) + g. It uses the future dividend D1, current price P0, and growth rate g.

What is the cost of debt after tax?

Cost = Interest \times (1 - Tax Rate).

What is unsystematic risk?

Risks for just one company that you can lower by buying different types of stocks.

What is systematic risk?

Market risks that affect everyone and cannot be avoided.

How do you turn equity beta into asset beta?

You take away the debt risk to see just the basic business risk.

Why change WACC for a new business?

Because new projects might have different risks than the old ones.

What is CAPM?

A simple rule to find out how much profit you should get for taking a risk.

What is levered beta?

A risk number that includes both the business and the debt.

What is unlevered beta?

A risk number that only looks at the business without any debt.

What is the WACC formula?

WACC = (E/V \times Cost\ of\ Equity) + (D/V \times Cost\ of\ Debt \times (1 - Tax)).

What is diversification?

Buying many different things so you don't lose all your money on one mistake.

Why use risk-adjusted WACC?

It gives a better price for a project based on its own specific danger.

How do you find adjusted net present value?

By using the risk-adjusted WACC to see what future money is worth today.

What is a proxy beta?

Looking at the risk of a similar company to guess the risk of your own new project.

Why is the 'adjusted present value' method good?

It lets you see the project value and the money value separately.

What 3 things does CAPM use?

The risk-free rate, the market return, and the asset's beta.

Why are weights important in WACC?

They show how much of the company is paid for by debt versus equity.

What happens if a company takes more debt?

WACC might go down because debt is cheap, but it might go up if it gets too risky.

What is the 'adjusted present value approach'?

A way to value a project by keeping the project and its debt separate.

How do you handle operating risk in WACC?

By changing the beta to ignore the debt or money risk.

What happens if beta is high?

It means there is more risk, so you should expect to earn more money.

What is the rule for risk and return?

If you take a bigger risk, you expect a bigger reward.

How do taxes help with debt?

Taxes make debt cheaper because the government lets you pay less tax.

Why care about what customers like for risk?

If customers change their minds, the company might lose money, which is a risk.

What does 'V' mean in WACC?

The total value of everything (Equity plus Debt).

What is hard about starting a new type of business?

The risk is different, so you have to calculate a new WACC.

Why check money risks in WACC?

To make sure the project's cost matches how much danger it has.

How do businesses change as they grow?

They look at their debts and change their WACC to match their new size.

Calculation: How do you find Cost of Equity using CAPM?

Formula: Re = Rf + \beta \times (Rm - Rf).

Example:

• Risk-free rate (R_f): 3\%

• Beta (\beta): 1.2

• Market Return (R_m): 10\%

• Calculation: 3\% + 1.2 \times (10\% - 3\%) = 11.4\%

Calculation: After-Tax Cost of Debt

Formula: K_d \times (1 - t).

Example:

• Interest Rate (K_d): 8\%

• Tax Rate (t): 25\%

• Calculation: 8\% \times (1 - 0.25) = 6\%

Calculation: Weighted Average Cost of Capital (WACC)

Formula: WACC = (we \times re) + (wd \times rd \times (1 - t))

Example:

• Equity Weight (w_e): 60\%

• Cost of Equity (r_e): 10\%

• Debt Weight (w_d): 40\%

• After-tax Debt Cost: 5\%

• Calculation: (0.60 \times 0.10) + (0.40 \times 0.05) = 0.06 + 0.02 = 8\%

The '4-Step Diagram' for Finding a Project's WACC

1. Find a Proxy: Identify a company in the same industry.

2. Unlever Beta: Remove the proxy's debt risk to find 'Asset Beta'.

3. Re-lever Beta: Add your company's debt risk to find your 'Equity Beta'.

4. CAPM: Plug the new Beta into the CAPM formula to find your project's cost.

Calculation: Unlevering Beta (Asset Beta)

Formula: \betaa = \frac{\betae}{1 + ((1 - t) \times (D/E))}

• \beta_a: Asset/Business Risk only.

• \beta_e: Equity risk (includes debt).

• Use this to 'clean' the risk of a proxy company.

Calculation: Re-levering Beta (Project Beta)

Formula: \beta{new} = \betaa \times (1 + ((1 - t) \times (D/E)))

• After finding the industry Asset Beta (\beta_a), use your own company's specific Debt-to-Equity (D/E) ratio to find the risk for your project.

Simplified Beta 'Diagram'

• Equity Beta (\beta_e): Business Risk + Financial (Debt) Risk.

• Asset Beta (\beta_a): Business Risk ONLY.

• Rule: More Debt = Higher Equity Beta.

Calculation: Dividend Growth Model

Formula: P0 = \frac{D1}{r_e - g}

To find Cost of Equity (r_e):

• re = (D1 / P_0) + g.

• If Dividends are \$2.00, Price is \$40, and Growth is 5\%

• Calculation: (2 / 40) + 0.05 = 10\%

Adjusted Present Value (APV) Breakdown

Formula: APV = Base\ Case\ NPV + PV\ of\ Financing\ Side\ Effects

• Base Case: Project value if it was financed 100\% by equity.

• Side Effects: The 'Tax Shield' benefit of using debt.

Diversification: Systematic vs. Unsystematic Risk

• Unsystematic (Diversifiable): Specific to one firm (e.g., a strike). Can be deleted by holding many stocks.

• Systematic (Market): Affects everyone (e.g., inflation). Cannot be deleted. This is what \beta measures.