CH13

LEARNING OBJECTIVES

• After studying this chapter, you should be able to:
  • 13-1: Calculate the weighted-average cost of capital (WACC).
  • 13-2: Understand when the WACC is—or isn’t—the appropriate discount rate for a new project.
  • 13-3: Measure a company’s capital structure.
  • 13-4: Estimate the expected returns on a firm’s securities.
  • 13-5: Use WACC to value a business given forecasts of its future cash flows.

RISK AND COMPANY COST OF CAPITAL

• In the previous chapter, the Capital Asset Pricing Model (CAPM) was used to estimate the expected return on a company’s common stock.
• When a firm is financed wholly by common stock:
  • Stockholders own all the firm’s assets and are entitled to all cash flows.
  • The return required by investors in common stock equals the company's cost of capital.
• Most companies use a mixture of securities (common stock, bonds, preferred stock) which complicates cost of capital calculations:
  • The company's cost of capital is no longer the same as expected returns on common stock.
  • It depends on the expected return from all issued securities.
• Taxes affect capital costs because interest payments are tax-deductible.
• WACC is typically calculated as a weighted average of the after-tax cost of debt and the cost of equity.

MANAGERS AND WACC

• Weighted-Average Cost of Capital (WACC): A tool for evaluating average-risk investment projects.
  • Average risk indicates that the project risk matches the firm’s existing assets and operations.
• WACC Calculation Fundamentals:
  • Set against the backdrop of Geothermal Corporation's need for financial evaluation amidst fluctuating energy prices and capital costs.