Learning Objectives
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# Learning Objectives - Calculate the Weighted Average Cost of Capital - Estimate cost of equity, cost of debt, and cost of preferred stock - Apply WACC in capital budgeting decisions ## 1. Cost of Debt **Before Tax:** Yield to maturity on existing debt.
Learning Objectives
- Calculate the Weighted Average Cost of Capital
- Estimate cost of equity, cost of debt, and cost of preferred stock
- Apply WACC in capital budgeting decisions
1. Cost of Debt
Before Tax: Yield to maturity on existing debt. After Tax: kd(1-t) - interest is tax deductible.
2. Cost of Equity
CAPM Approach: E(R) = Rf + beta(Rm - Rf) Dividend Discount Model: Re = D1/P0 + g (growth rate) Bond Yield Plus Risk Premium: Re = Rd + equity risk premium
3. WACC
Worked Example:
- Debt: 40% of capital, kd=8%, tax=30%
- Equity: 60%, ke=12% WACC = 0.40 x 8% x (1-0.30) + 0.60 x 12% = 0.40 x 5.6% + 0.60 x 12% = 2.24% + 7.2% = 9.44%
| Concept | Formula |
|---|---|
| After-tax Cost of Debt | kd(1-t) |
| Cost of Equity (CAPM) | Rf + beta(Rm - Rf) |
| Cost of Equity (DDM) | D1/P0 + g |
| WACC | wd kd(1-t) + we ke + wp kp |
Q1: Company has 50% debt, 50% equity. kd=6%, tax=25%, ke=11%. WACC?WACC = 0.5 x 6% x 0.75 + 0.5 x 11% = 2.25% + 5.5% = 7.75% Q2: Why use after-tax cost of debt?Interest expense is tax-deductible, reducing the effective cost. Q3: How does the DDM estimate cost of equity?Re = D1/P0 + g. D1 is expected dividend, P0 is current price, g is growth rate. Q4: If a firm takes on more debt, what happens to WACC?Initially WACC may decrease due to tax shield. But as financial risk increases, both kd and ke rise, eventually increasing WACC. Join Discord PreviousRisk, Return & CAPMNextCapital Structure Theory