Finance Reading: Cost of Capital
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Publication Date:
May 04, 2017
Source:
Harvard Business Publishing
Core Curriculum Readings in Finance provide an understanding of fundamental concepts in finance. Readings include Interactive Illustrations to help readers master complex concepts.
This Reading introduces practical problems encountered when estimating and applying the cost of capital in a DCF valuation. It applies, but does not derive, key ideas from modern portfolio theory and is accessible to readers who have not yet studied portfolio theory. The reading begins by defining the cost of capital narrowly, as a discount rate (in a DCF valuation) that must equal the opportunity cost of funds, or equivalently, the sum of the time value of money and a risk premium. This intuitive explanation is followed by the CAPM equation, and practical discussions of systematic risk, beta, and the equity market risk premium. The Reading then introduces WACC as an alternative calculation for the cost of capital and shows, graphically and mathematically, the correspondence between CAPM and WACC in the absence of taxes. The Reading also explains that the “(1-t)” adjustment term in the formula for WACC with taxes compensates for missing interest tax shields in the standard calculation of Free Cash Flow. The next section is a step-by-step explanation of how to calculate WACC for a real company, including discussions of data and sources commonly used by practitioners to compute leverage ratios, the cost of debt, the tax rate, the risk-free rate, and so forth. Finally, the reading walks through an illustrative calculation of WACC for Coca-Cola, as of December 31, 2015, using data from Coca-Cola’s SEC filings and the capital markets. The Supplemental Reading section examines some of the limitations of WACC as a discount rate as well as some common errors that practitioners make in computing and using WACC. It also covers two alternatives to WACC-based DCF, the APV and CCF methods.
The Reading includes three interactive illustrations. Interactive 1 shows that in the absence of taxes and costs of financial distress, WACC equals the cost of unlevered equity. Interactive 2 demonstrates how to use comparable firms to estimate beta, using unlevering and re-levering formulas. Interactive 3 allows readers to review what they have learned about how to compute individual elements of WACC and put them together in a completed calculation.
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Finance Reading: Cost of Capital
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