I Jo Ann Cox needs to calculate the required rate of return on this geothermal plant.
' How should she do it? © Cameramann International, Ltd.
© The McGraw-Hill Companies, 2001 Finance, Third Edition n the last chapter you learned how to use the capital asset pricing model to estimate the expected return on a company's common stock. If the firm is financed wholly by common stock, then the stockholders own all the i's assets and are entitled to all the cash flows. In this case, the expected return required by investors in the common stock equals the company cost of capital.1
Most companies, however, are financed by a mixture of securities, including common stock, bonds, and often preferred stock or other securities. Each of these securities has different risks and therefore investors in them look for different rates of return. In these circumstances, the company cost of capital is no longer the same as the expected return on the common stock. It depends on the expected return from all the securities that the company has issued. It also depends on taxes, because interest payments made by a corporation are tax-deductible expenses.
Therefore, the company cost of capital is usually calculated as a weighted average of the after-tax interest cost of debt financing and the "cost of equity," that is, the expected rate of return on the firm's common stock. The weights are the fractions of debt and equity in the firm's capital structure. Managers refer to the firm's weighted-average cost of capital, or WACC (rhymes with "quack").
Managers use the weighted-average cost of capital to evaluate average-risk capital investment projects. "Average risk" means that the project's risk matches the risk of the firm's existing assets and operations. This chapter explains how the weighted-average cost of capital is calculated in practice.
After studying this chapter you should be able to
► Calculate a firm's capital structure.
► Estimate the required rates of return on the securities issued by the firm.
► Calculate the weighted-average cost of capital.
► Understand when the weighted-average cost of capital is—or isn't—the appropriate discount rate for a new project.
Managers calculating WACC can get bogged down in formulas. We want you to understand why WACC works, not just how to calculate it. Let's start with "Why?" We'll listen in as a young financial manager struggles to recall the rationale for project discount rates.
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