## Corporate Finance Basics

### How do
I calculate WACC?

#### In
order to calculate a weighted average cost of capital
there are a
few pieces of information that we need to know:

#### TheW_{d}= The
proportion of the
financing
taken on by debt (amount of
capital taken from loans/initial investment)

The W_{pfd}= The proportion of
the financing
taken provided by preferred
stock (amount of capital taken from preferred stock/initial investment)

The W_{e}= The proportion of the
financing
provided by equity (amount of
capital raised by new equity/initial investment)

The after tax K_{d}= The cost of
debt x ( 1-
tax rate) or the interest
rate that
the bank requires

The K_{pfd}= dividend/share price

The K_{e}= R(r)+ Beta (Market Risk
Premium)

The initial investment

The tax rate

We are now able to calculate the WACC which =

### W_{d}(K_{d})(1-t)+(W_{pfd})(K_{pfd})
+(W_{e})(K_{e})

#### Here is a numerical
example:
We want to start a company that requires an initial investment of
$100,000. Our company that will manufacutre plastic shower caddies will
require use of all $100,000. We are able to take out a loan of $25,000
from a local bank; $50,000 by issuing common stock to family, friends,
and professors; and $25,000 of preferred stock to a generous alumna of
MHC. There is an 8% interest rate on our loan; and we agreed to pay our
alumna 6% return. We do some research and see that a company who only
manufactures plastic shower caddies has a beta of .85 with no outstanding
debt. Our risk free rate is 4.4% and market risk premium is 6.6%. The
tax rate is 30%. What is
our required return on our investment that we will use to find a present
value of our company, in other words, our WACC?

SOLUTION:

#### Wd= 25,000/100,000 = .25

W_{e}= 50,000/100,000 = .5

W_{pfd}= 25,000/100,000 = .25

K_{d}= .08

K_{e}= .044+.85(.066) = .10

K_{pfd}= .06

#### Now we can substitute into our equation:

#### WACC= (.25)(.08)(1-.3)+(.5)(.1)+(.25)(.06)

WACC= .014+.05+.015

= .079

= 7.9%

#### When finding a rate of return for an individual
project, we must remember that WACC is only appropriate for an
individual project when its risk is equal to the risk of the company as a
whole. If there is added or subtracted risk to the firm from the project,
the required return must be adjusted.

A new Beta for the project must be found by using the Hamada
Equation:

#### Beta of assets= Beta of equity/ [1+(1-t)(D/E)]

#### Then a new return can be calculated using this new
Beta:

#### Risk Adjusted Discount Rate= risk free rate+ (beta of
assets)(market risk premium)

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