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WACC - Coggle Diagram
WACC
Equity
Dividend valuation model
Market value of ordinary share represents future expected dividend flow discounted to PV
Market value = dividend / cost of equity
Dividend is generally one of the major determinants of equity value
CAPM
Limits
Assumption that government bonds are risk free
Assumption of perfect capital market
Use Beta as measure of systematic risk
May be difficulties in finding suitable proxy Beta
Single period model
Lever/ unlever
Use similar company Beta and take out debt then add entities debt back to get entities Beta
Will give formula to lever / unlever
Used in
Investment appraisal
WACC
CAPM = Rf + Beta(Rm - Rf)
Market value if constant growth = Dividend / (cost of equity - constant growth)
Debt
Advantages
Debt is cheaper than equity because
Debt (except pref shares) = tax deductable
Higher risk = higher return
Equity carries higher risk
Disadvantages
Business risk
Finance risk increase
Financial gearing
Portion of debt compared to equity
High financial gearing
High reliance on debt
Increase risk
Ratios
Gearing ratio = long term debt / (long term debt - equity)
Debt (solvency) ratio = total debt / total assets
Debt : equity ratio = non-current liabilities / equity
Traditional capital structure theory
Debt capital has lower after tax cost
As debt increase - WACC decrease
Company cannot max SH wealth unless optimal WACC achieved
Optimal WACC exist and depend on gearing
Assumptions
Project is marginal
Project = risk as entities existing activities
Firm will retain existing proportion of debt:equity
Common mistakes
Using D:E ratio instead of %
Using short term instead of long term target ratios
Using book values instead of market values
Hurdle rate
Make sure value is added
Don't just break even on WACC
WACC + %
Types
Target WACC
Book value (last resort)
Market value