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The other approach is the CAPM, To find the cost of equity, We have the cost of debt and cost of
which was developed by Sharpe, a equity; now we need to find the firm’s
Nobel Prize winner in economics in Re = 5 + 1.15(9) = 15.35% value. The values are as follows:
1990.
Remember the market risk premium Equity market value E = 50 million
Re = Rf + ßex (Rm - Rf ) is Rm-Rf. Since this is given, we need ($80) = $4 billion
not deduct 5% from 9%. Debt market value D = $1 billion
Using CAPM, the risk free rate (Rf ) (1+110%) = $1.1 billion
and market return (Rm) have to be To find cost of debt, we turn to the Firm market value V = E + D = $5.1
found, as does the stock’s beta. There bond pricing equation and find r. billion
are many arguments about how
best to determine the risk free rate, P = C x [1 - 1/(1 + r )t]/r + Weight of E = E/V = $4 /$5.1 =
market return and the beta. However, F x 1/(1 + r )t 0.7843
CAPM is relatively more commonly Weight of D = D/V = $1.1 /$ 5.1
used than the dividend growth model We may assume the face value of = 0.2157
since most stocks do not have a stable individual bond = $1,000. Since
dividend history. C = $45 (remember it’s a semi-
annual payment), t = 30, P = $1,100,
When calculating the cost of debt, F=$1,000, we find that r = 3.9268%.
So, what is the WACC? Students must bear in mind that in order to include a risk cushion in
WACC is affected not only by Re their project evaluation. The logic
WACC = 0.7843(15.35%) + and Rd, but it also varies with capital behind this is simple as the process
0.2157(6.6759%) = 13.48% structure. Since Rd is usually lower of finding WACC involves a large
than Re, then the higher the debt degree of estimation: you need to
This rate is used in the evaluation level, the lower the WACC. This estimate the risk free rate, the beta
of a project NPV or in determining partly explains why firms usually and the market return.
the value of an asset. Why is WACC prefer issuing debt first before they
important? For a project to be feasible, raise more equity. So next time you tackle a WACC
not just profitable, it must generate a question, remember this process. In
return higher than the cost of raising As part of their risk management real life the process is similar, just
debt (Rd) and the cost of raising processes, some companies add a more complicated as a company may
equity (Re). risk factor, say 1.5%, to the WACC have different debts with different
interest rates.