WACC & Cost of Capital
Compute WACC and use it as the discount rate for project valuation. Understanding cost of capital is crucial for corporate finance decisions because it sets the minimum return a firm must earn. The calculation blends the cost of equity (usually from CAPM) with the after-tax cost of debt, weighted by market values.
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Study Tips
- ✓Use market-value weights, not book
- ✓Tax-adjust debt only
- ✓Keep assumptions explicit
- ✓Check if the problem specifies book or market weights
Common Mistakes to Avoid
Mixing book-value and market-value weights in one calculation. Also forgetting the tax shield on debt. Preferred stock dividends are not tax-deductible, so only the debt component gets the (1-T) adjustment.
WACC & Cost of Capital FAQs
Common questions about wacc & cost of capital
Not always. Riskier projects often need a higher discount rate than the firm-wide WACC. Use a project-specific rate when the project's risk profile differs significantly from the company's average operations.
Interest is tax-deductible and debt has priority in bankruptcy, so investors accept a lower return. The after-tax cost of debt is even lower because the government effectively subsidizes interest payments through the tax deduction.
Rearrange the Gordon Growth Model: Re = D1/P0 + g, where D1 is next year's dividend, P0 is the current stock price, and g is the dividend growth rate. This works best for mature, stable dividend-paying companies.
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