BFF2140 Chap.7 Cost of Capital and WACC
Cost of Capital and WACC
Cost of Capital and WACC combines investor required returns into a firm-level opportunity cost. Debt, preference shares and ordinary equity are estimated separately, then weighted by current market values. Interest receives an after-tax adjustment, but equity does not. The resulting WACC is appropriate only when project risk and financing remain consistent with the benchmark firm.
Each component represents the return currently required by the investors supplying that capital. Market values provide the relevant weights because they measure the economic financing amounts at today's opportunity cost, whereas book figures are historical accounting records. Debt cost may be inferred from its current yield and is adjusted for the interest tax effect under the model.
Equity cost can be estimated through CAPM or another supported approach, and preference shares remain a separate component when present. The weighted contributions should sum to a rate between the adjusted component costs. That arithmetic result is not automatically the correct hurdle for every project.
Corporate WACC fits investments with operating risk and financing like the existing firm; a different-risk project needs a rate grounded in a closer comparable. The chapter therefore emphasises both the construction of the financing table and the judgment that matches a discount rate to the cash flow being valued.
What this chapter covers
- 01
Cost of debt
- 02
Cost of preference shares
- 03
Cost of ordinary equity
- 04
Market-value weights
- 05
After-tax WACC
- 06
Project-specific discount rates
- 07
Auditable component contributions and the conditions required before corporate WACC can be used as a project hurdle
Worked example · free
Compute market-value WACC
- 3Market weights are 0.60 equity and 0.40 debt; after-tax debt cost is 6% multiplied by 0.70, or 4.2%.
- 3WACC is 0.60 times 12% plus 0.40 times 4.2%, which equals 8.88%.
Key terms
- Cost of equity
- The return ordinary shareholders require for bearing the firm's equity risk.
- After-tax debt
- The debt required return multiplied by one less the corporate tax rate.
- Market-value weight
- A financing source's current value divided by total current financing value.
Cost of Capital and WACC FAQ
Why use market values?
Required returns apply to capital at today's opportunity cost. Market values reflect the current economic amounts supplied by investors, while historical book values can be far removed from those amounts.
Why is debt adjusted for tax?
Interest is deductible under the model used in the course, so the firm bears the debt cost net of the resulting tax saving. Dividends do not receive the same corporate deduction.
Can one WACC value every project?
No. Corporate WACC suits projects with risk and financing like the existing firm. A project with materially different systematic risk needs a discount rate based on a closer risk comparison.
Exam move
Construct WACC through an auditable component table. List each source of long-term finance, its current market value, its weight, its required return and any tax adjustment. Reconcile market values to total financing and weights to one before multiplying.
Estimate debt cost from the return creditors currently require, not from a historical coupon alone, and apply the corporate tax adjustment only where the model permits interest deductibility. Keep preference shares separate when they exist. Estimate ordinary equity cost with the method supported by the information, such as CAPM or a dividend-growth relation, and state the assumptions behind that estimate.
Multiply each component return by its market-value weight and add the contributions; WACC should normally fall between the lowest and highest adjusted component costs. Use that range as an arithmetic check. Do not substitute book weights merely because they are easier to find, since the required return applies to capital valued at today's opportunity cost.
Practise cases where new debt changes leverage and therefore the equity return rather than assuming component costs remain fixed. The most important written judgment is whether corporate WACC fits the project. It is a suitable benchmark only when operating risk and the financing pattern are comparable with the existing firm.
For a substantially different project, identify a risk-matched comparable, separate operating risk from its leverage and rebuild a project rate under the intended financing assumptions. Explain why adding an arbitrary premium is weaker than a traceable risk adjustment.
Maintain an error log for tax applied to equity, weights based on face value, market premium confused with market return and percentages entered as whole numbers. Recalculate the table from component contributions if the total looks implausible. Finish every answer by stating the valuation use: WACC discounts project free cash flow available to all capital providers, not an equity-only cash flow.
A formula-sheet entry supplies the relationship, but the marks are protected by correct inputs, consistent cash-flow ownership and a reasoned statement about project risk.
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