Table 151

Summary of Capital Cost Calculations

I. The cost of equity, RE

A. Dividend growth model approach (from Chapter 8):

Re = D1/Po + g where D1 is the expected dividend in one period, g is the dividend growth rate, and P0 is the current stock price.

B. SML approach (from Chapter 13):

where Rf is the risk-free rate, RM is the expected return on the overall market, and pE is the systematic risk of the equity.

II. The cost of debt, RD

A. For a firm with publicly held debt, the cost of debt can be measured as the yield to maturity on the outstanding debt. The coupon rate is irrelevant. Yield to maturity is covered in Chapter 7.

B. If the firm has no publicly traded debt, then the cost of debt can be measured as the yield to maturity on similarly rated bonds (bond ratings are discussed in Chapter 7).

III. The weighted average cost of capital, WACC

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

B. The WACC is calculated as:

where TC is the 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. Note that E/V is the percentage of the firm's financing (in market value terms) that is equity, and D/V is the percentage that is debt.

EXflMPLE 155 I Usi"3 the WACC

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