Question

How do you compute the capital structure weights required for the WACC?

What are two methods that can be used to compute the appropriate discount rate when WACC isn’t appropriate?

What happens if we use the WACC as the discount rate for all projects?

Answer 1

• Weighted average cost of capital (WACC) is the average after-tax cost of a company’s various capital sources, including common stock, preferred stock, bonds, and any other long-term debt.

• WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight, and then adding the products together to determine the WACC value.

-->> two methods that can be used to compute the appropriate discount rate :-

A. A firm's WACC is overall required return on the firm as a whole . It is the appropriate discount rate to use for cash flows smilar in risk to those of the overall firm .

B. The WACC is calculated as :-

WACC = ( E/V) x RE + ( D/V ) x RD x ( 1- TC )

Where, TC is corporate tax rate , E is the market value of the firm's equity, D is the market value of the firm's debt , and V = E+D .

Noted that E/V is the percentage of the firm's financing

( in market value term ) that is equity, and D/V is the percentage that is debt.

-->> if we use the WACC as the discount rate for all projects.

• using the WACC as our discount rate is only appropriate for project that have the same risk as the firm's current operation.

• if we are looking for a project that does NOT have the same risk as the firm , then we need to determine the appropriate discount rate for that project.

• Division also often require seperate discount rates.