Wacc Essay

1244 WordsMay 13, 20155 Pages
First ensure that you have read relevant pages in the text. Some important sections would include the following, but you may also double-check the references in the text by using the index [see: Cost of Capital and Target (optimal) Capital Structure, etc.]: The important Chapter in the text is the one entitled "The Cost of Capital," – with a particular focus on the section entitled “The Weighted Average Cost of Capital” and the section “Four Mistakes to Avoid” at the end of the chapter. The WACC formula discussed below does not include Preferred Stock. Should your company use PS, be sure to adjust the equation for it, and see the section in the chapter on the Cost of Preferred Stock. The WACC formula that we use is: WACC = wdrd(1-T) + wsrs We need to know how to calculate: 1. rs the cost of common equity. Use the Security Market Line (SML) – this is why you learn how to calculate a company’s beta and also why you learn how to find the appropriate risk-free rate and market-risk premium. For a review, see the section the text, The CAPM Approach. 2. The weights (wd and ws – note that: wd + ws = 1; so you only have to calculate one of them). We need to calculate the weight of debt and the weight of equity (for the cost of debt, this simply means: what proportion of the firm’s financing is by debt?). There is a lot to say here, simplified as Theory 1, Theory 2 and Practice: a. Theory 1: Theory says that we should use the target weights along with the market values of both debt and equity (see the Four Mistakes to Avoid). But the market value of debt is typically difficult to calculate, because we need to know the YTM (which is rd) for all of the company’s debt, but we cannot calculate the YTM without having the current prices of the company’s outstanding bonds, and most company’s bonds do not trade (i.e., they will

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