Module 4

Company Investment Decisions

Using the Weighted Average Cost of
Capital
 Definition of WACC
• It is simply a discount rate that combines the
capital costs of all of the various types of capital
claims that a company issues. Thus it may
include the costs of equity capital, debt capital,
and any other capital claims outstanding. The
weighted average cost of capital is a convenient
measure for a company to use, because it
captures in a single discount rate all of the
returns necessary to service the company’s
capital claims.
 Free Cash Flow and Profits for
Borrowing Corporations
• Lets look at example on page 4/2.
• Interest Tax Subsidy – Interest x Tax Rate
 Investment Value for Borrowing
Corporations
• Table 4.5
Overall Corporate Cash Flows and
Investment Value.
Overall rate= [MVE/MVE + MVD ] x RE +
[MVD/MVE +MVD] x RD.
Investment NPV and the Weighted
Average Cost of Capital
Cash Flows - The common practice in financial
analysis of corporate investment is that, when
estimating the cash flows of a project, its interest
tax shields are not included in the cash flows. In
other words, the cash flows are calculated as if
the project will be financed totally with equity,
even if the financing plan is actually to use debt.
Calculating NPV using WACC.
WACC= [MVE/MVE + MVD ] x RE + [MVD/MVE
+MVD] x RD (1-T).
Investment NPV and the Weighted
Average Cost of Capital
• The weighted average cost of capital
(WACC) is the discount rate that:
1) reflects the operating risks of the project;
2) reflects the project’s proportional debt
and equity financing with attendant
financial risks; and
3) reflects the effect of interest deductibility
for the debt financed portion of the
project.
 Investment NPV and the Weighted
Average Cost of Capital
• The WACC–NPV, does not require that the exact
amount of debt to be used in the project be known in
order to calculate the project’s NPV. The cash flows
used in the WACC–NPV are those that would be
expected if the investment were all equity financed.
• It does not require the market values of any of the
resulting claims be estimated beforehand. The only
information necessary comprises estimates of the
required rate for equity, debt’s after tax cost rate, the all
equity free cash flows, and the proportions intended for
debt and equity financing.
 The Adjusted Present Value
Technique
• APV finds the NPV by:
1)finding the value of an investment as if it
were financed only by equity i.e. valuing
the asset cash flows which excludes
interest expense,
2)adding the present value of the project’s
interest tax shields.
Lets look at the calculation (4/15).
 WACC vs APV
• Recall that WACC–NPV requires that the
proportions of debt and equity market values be
known, but that knowledge of the cash amounts
of such financing is not necessary for the final
result. The APV, on the other hand, does not
require that the proportions of debt and equity
be known, but does require that the interest tax
shields of the project’s debt be estimated.
Otherwise the information required by the two
techniques is basically the same.
 WACC vs APV cont.
• The APV technique is therefore preferred for
corporations comfortable in estimating the
amounts of debt their projects will use, but
not the value proportions that will be
generated, while the WACC–NPV method is
best for companies that are willing to estimate
market value proportions of financing for
investments, but not the actual amounts that
will be generated.