Question

What is “Weighted Average Cost of Capital” and how is it used in equity valuation?

Which is the better model for valuation when earnings quality is a major concern, DCF or ROPI? Explain.

Discuss why NOPAT is used in calculating the value of a company instead of net income in the ROPI equity valuation model.

Answer 1

As per policy, only one question can be answered at a time, but here two questions are answered for you :

1) The weighted average cost of capital (WACC) is an average cost of capital which is calculated of cost involved in raising capital through each element of the capital structure with having proportionate weight of each of the element like common stock, preferred stock, bonds and other debts. Formula : WACC = Wd * Cd * ( 1 - T) + We * Ce

The WACC is being used to get ‘expected returns of the firm’ under the “Discounted Cash Flow (DCF) valuation model” to value the cost of equity. Higher the WACC, higher the value of equity.

2) The better model for valuation is “DCF” when earnings quality is a major concern because ROPI involves return on Operating Income (which is supposed to be unstable), on other side, the income is not involved while doing valuation through DCF Model, it involves only expected cost with the help of WACC and cost of debt.