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Here is the basic formula for weighted average cost of capital:

WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)]

E = Market value of the company's equity


D = Market value of the company's debt
V = Total Market Value of the company (E + D)
Re = Cost of Equity
Rd = Cost of Debt
T= Tax Rate

Assume newly formed Corporation ABC needs to raise $1 million in capital so it can buy office
buildings and the equipment needed to conduct its business. The company issues and sells
6,000 shares of stock at $100 each to raise the first $600,000. Because shareholders expect a
return of 6% on their investment, the cost of equity is 6%.

Corporation ABC then sells 400 bonds for $1,000 each to raise the other $400,000 in capital. The
people who bought those bonds expect a 5% return, so ABC's cost of debt is 5%.

Corporation ABC's total market value is now ($600,000 equity + $400,000 debt) = $1 million
and its corporate tax rate is 35%. Now we have all the ingredients to calculate Corporation
ABC's weighted average cost of capital (WACC).

WACC = (($600,000/$1,000,000) x .06) + [(($400,000/$1,000,000) x .05) * (1-0.35))] = 0.049 =


4.9%

Corporation ABC's weighted average cost of capital is 4.9%.

This means for every $1 Corporation ABC raises from investors, it must pay its investors almost
$0.05 in return.

ExxonMobil Corporation (NYSE: XOM) has a beta coefficient of 0.88. Estimate its cost of
equity if the risk free rate is 4% and return on the broad market index is 8%.

Solution

Under capital asset pricing model,

Cost of equity = risk free rate + beta coefficient equity risk premium

Equity risk premium = broad market return risk free rate


Cost of equity = risk free rate + beta coefficient (broad market return risk free rate)

Cost of equity (XOM) = 4% + 0.88 (8% 4%) = 4% + 0.88 4% = 7.52%

The required return (cost of equity) estimated based on CAPM should be compared with the
investor expectation of return on the stock keeping in view the companys operations and future
growth potential. If the expected return is higher than the required return, the stock is a good
investment (on standalone basis) and vice versa.

Example for discounting nominal and real cash flows:ve $10 000 at the end of each year.
These cash flows are nominal cash flows because, they are not adjusted for inflation, thus
we use nominal interest rate of 10% to find the present value (PV) of the cash flows.

Suppose you have made an investment expect to receive net cash flow of $30 000 in three
equal installments ($10,000) at the end of each year over the next three years. Currently
nominal interest rate which is also your opportunity cost of capital is 10% and you expect
annual inflation rate to be 3% over the next three years. What is the present value of these
cash flows in nominal and real terms.

Nominal cash flow discounting: We know that over the next three years we are going to
receive:

PV (nominal) = $10 000/1.10 + $10 000/1.12 + $10 000/1.13 =$24,869

Real cash flow discounting: We are expecting the prices to increase, thus the purchasing
power of each $10,000 will not be the same. For example, in the first year you can buy 10
laptops worth $1,000 each. If the price of a laptop increases by 3% to $1,030 at the end of
the second year, we can no longer purchase 10 laptops and, when laptop prices increase by
the same amount in the 3rd year to $1,060.90, we can purchase even fewer laptops.

Thus, the real value of cash flows is found by adjusting nominal cash flows for the inflation
rate as follows: 10,000/1.03 = $9,709 for the first year, $10,000/1.032 = $9,426 for the
second year and $10,000/1.033 = $9,151.4 for the third year. (see below the table)

Cash flows 1st year 2 nd year 3rd year


Nominal cash flows $10,000 $10,000 $10,000
Real values of cash flows $ 9,709 $9,426 $ 9,151

When we discount these cash flows, we need to estimate real interest rates using the
following formula:
Rr =(1+Rn) / (1+i) -1 = (1+10%) / (1+3%) - 1 6.8%

Eventually we discount real cash flows by real discount rates:

PV (real) = $9,709 /1.068 + $9,426/1.0682 +$9,151/1.0683 = $24,869

Thus, the PV of real and nominal cash flows are the same. (note: we have ignored rounding
effects in real cash flow discounting)

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