An Introduction to Corporate Finance: Transactions and Techniques, Second Edition

Chapter 9

DETERMINING THE COST OF CAPITAL

The previous chapter introduced the DCF approach to company valuation. We noted that the approach was the most scientific, but suffered from limitations – in particular, the accuracy of cash flow forecasts. A second issue affecting the accuracy of DCF valuations is the selection of an appropriate rate at which to discount the cash flows.

 

The discount rate that is to be used is the firm’s ‘cost of capital’; that is, the amount (in percent) that the firm must ‘pay’ to its providers of capital. In Chapter 2 we discussed the various sources of capital available to corporations, from commercial paper, to convertible bonds to ordinary shares. Each source of capital has a cost – some higher than others. Corporate financiers work with their clients to minimise the firm’s cost of capital because as the discount rate declines the firm’s value increases.

 

In this chapter we will focus on the costs of the two main sources of capital: debt and equity.

WEIGHTED AVERAGE COST OF CAPITAL

When trying to determine the correct discount rate, corporate financiers calculate a weighted average of the cost of each component or source of finance (capital). The Weighted Average Cost of Capital (WACC) is also known as the opportunity cost of capital (i.e., the amount of return that a rational investor requires for an investment of similar risk).

 

The WACC is calculated on an after-tax basis, since free cash flows represent cash available to all providers of ...