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Submitted By mark6241

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Words 1170

Pages 5

Weighted Average Cost of Capital WACC (and derived methods) and Adjusted

Present Value (APV)1.

For practical purposes, as is often the case of many larger firms in industrialized economies, whenever a target debt ratio is set up for the long term,

WACC and its associated methods might be an acceptable approximation.

However, the situation is different in a considerable number of instances:

The weighted average cost of capital (WACC) is a common topic in the financial management examination. This rate, also called the discount rate, is used in evaluating whether a project is feasible or not in the net present value (NPV) analysis, or in assessing the value of an asset. Previous examinations have revealed that many students fail to understand how to calculate or understand

WACC. WACC is calculated as follows:

WACC = E/V x Re + D/V x Rd x (1-tax rate)

WACC is the proportional average of each category of capital inside a firm – common shares, preferred shares, bonds and any other long-term debt – where:

Re = cost of equity

Rd = cost of debt

E = market value of the firm’s equity

D = market value of the firm’s debt

V = E + D = firm value

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

WACC is simply a replica of the basic accounting equation: Asset = Debt + Equity. WACC focuses on the items on the right hand side of this equation. (Most companies do not have preferred shares. For simplicity, we only use common shares and bonds in our illustrations.)

A firm derives its assets by either raising debt or equity (or both). There are costs associated with raising capital and WACC is an average figure used to indicate the cost of financing a company’s asset base.

In determining WACC, the firm’s equity value, debt value and…...

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