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Hope my last post on myth
behind numbers helps you in developing insight to look beyond numbers while
making a decision about company or projects because numbers are often illusory in
nature, one can easily twist and manipulate it as per one’s advantage. Hence,
be careful while taking decision just on the basis of numbers.
Let’s start today’s post
from the point where I left my fourth post. I think after getting through my
previous posts you can easily calculate the FCFF or FCFE, if the balance sheet
of the company is given. But the real problems lie in calculating or making
assumptions about the factors that I had mentioned in my fourth post. These
factors are quite important for calculating the enterprise value. Today, I am
going to explain to calculate one’s such factor that is how to calculate Cost of Capital. Please keep in mind that it is
the same cost of capital/WACC that is used to discount all the future cash
flows to find enterprise values. Since, it involves many sub factors; it will
take minimum 5 to 6 post to cover the whole concepts. Now, before getting into
the details please look at the factors essentials to consider before
calculating Cost of capital or WACC. These factors are as follows:
Factors

Consideration

Models used

If you are using FCFF for your
calculation then use cost of capital for discounting else use cost of equity
for FCFE. Any mismatching will lead to erroneous results

Currency used

The currency used for estimating
cash flows and discount rate should be same.

Inflation

If you consider inflation in your
cash flow i.e. calculating Nominal cash flow then discount rate should be
nominal and vice versa.

. The formula to calculate WACC is given by
WACC = (E/V) * Ke + D/V * ( Kd) * (1Tc)
Where:
Ke = cost of equity
Kd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Ke = cost of equity
Kd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
From, the formula it is clear that while calculating firm’s cost
of capital each category of capital is proportionately weighted. Generally, a
company’s assets are financed by either debt or equity. WACC is the average of
the costs of these sources of financing, each of which is weighted by its
respective use in the given situation. By taking a weighted average, we can see
how much interest the company has to pay for every dollar it finances.
The first thing that we
will have to consider in order to calculate Cost of Capital is Cost of Equity.
The most common method used to calculate Ke is CAPM Model. It basically
describes the relationship between risk and expected return and that is
used in the pricing of risky securities.The formula
is given by
Ke = Rf + Beta* ( RmRf)
The general idea behind CAPM is that investors need to be
compensated in two ways: time value of money and risk. The time value of
money is represented by the riskfree (Rf) rate in the formula and
compensates the investors for placing money in any investment over a period of
time. The other half of the formula represents risk and calculates the amount
of compensation the investor needs for taking on additional risk. This is
calculated by taking a risk measure (beta) that compares the returns of
the asset to the market over a period of time and to the market premium
(RmRf). Please remember that there are many complexities while calculating Ke,
which I will discuss in my next post.
Hope this post helps you in understanding the basics of Cost of
capital. Be ready to enter the world of risk free rate in my next post.
If you want to get customized help regarding valuation
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