Weighted Average Cost of Capital A firm normally finds its weighted average cost of capital (WACC)by combining the cost of equity with the cost of debt in proportion to the relative weight of each in the firm's optimal long-term financial structure: kwxcc=k.+ka(1-)
Weighted Average Cost of Capital A firm normally finds its weighted average cost of capital (WACC) by combining the cost of equity with the cost of debt in proportion to the relative weight of each in the firm’s optimal long-term financial structure: kWACC = keE + kd (1-t)D V V
Weighted Average Cost of Capital kwAcc weighted average after-tax cost of capital ke risk-adjusted cost of equity k=before-tax cost of debt t marginal tax rate E market value of the firm's equity D market value of the firm's debt V total market value of the firm's securities =(D+E)
Weighted Average Cost of Capital kWACC = weighted average after-tax cost of capital ke = risk-adjusted cost of equity kd = before-tax cost of debt t = marginal tax rate E = market value of the firm’s equity D = market value of the firm’s debt V = total market value of the firm’s securities =(D+E)
Weighted Average Cost of Capital The capital asset pricing model (CAPM)approach is to define the cost of equity for a firm by the following formula: ke=kt+βkm-k) ke expected (required)rate of return on equity Krf=rate of interest on risk-free bonds (Treasury bonds,for example) B=coefficient of systematic risk for the firm km expected (required)rate of return on the market portfolio of stocks
Weighted Average Cost of Capital The capital asset pricing model (CAPM) approach is to define the cost of equity for a firm by the following formula: ke = krf + βj(km – krf) ke = expected (required) rate of return on equity krf = rate of interest on risk-free bonds (Treasury bonds, for example) βj = coefficient of systematic risk for the firm km = expected (required) rate of return on the market portfolio of stocks
Beta B can be interpreted as measure of how risky this asset is compared to the general risk level in the market β<1："low"risk asset B 1 "high"risk asset Systematic vs.firm specific risk --Systematic risk:risk of holding the market portfolio --Firm specific risk:risk that is unique for the asset According to CAPM,the market compensates investors for taking systematic risk but not for taking specific risk since the specific risk can be diversified away!
Beta β can be interpreted as measure of how risky this asset is compared to the general risk level in the market β < 1 : "low" risk asset β > 1 : "high" risk asset Systematic vs. firm specific risk --Systematic risk: risk of holding the market portfolio --Firm specific risk: risk that is unique for the asset According to CAPM, the market compensates investors for taking systematic risk but not for taking specific risk since the specific risk can be diversified away!
Weighted Average Cost of Capital --Calculating cost of equity in practice I 传 How to estimate B 1 Choice of proxy for the market portfolio 2 Time period:6 months,1 year,5 years or .. 3 Returns:daily,weekly or monthly observations? 4 Use the market model (regression) ke=kr+β(km-k) 5 Reality check does this seem reasonable? -1 usually0<β<2 --2 Market portfolio B 1
Weighted Average Cost of Capital --Calculating cost of equity in practice I How to estimate β 1 Choice of proxy for the market portfolio 2 Time period: 6 months, 1 year, 5 years or ... ? 3 Returns: daily, weekly or monthly observations? 4 Use the market model (regression) ke = krf + βj(km – krf) 5 Reality check - does this seem reasonable? --1 usually 0<β<2 --2 Market portfolio β = 1