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Suppose you are estimating the cost of capital for a firm within the corporate value model....

Suppose you are estimating the cost of capital for a firm within the corporate value model. Explain briefly how you determine the input values for the WACC; in particular, 1) the weights and 2) cost of debt.

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Answer #1

The weights are determined as shown below:

We are assuming that the firms capital structure consists of debt and equity

Weight of debt is computed as follows:

= Market value of debt / (Market value of debt + Market value of equity)

Weight of Equity is computed as follows:

= Market value of equity/ (Market value of debt + Market value of equity)

Cost of debt will be computed as follows:

= YTM (1 - tax rate)

Cost of equity as per CAPM model is determined as follows:

= risk free rate + beta ( return on market - risk free rate)

Cost of equity as per dividend growth model is determined as follows:

= Dividend expected in next year / (required rate of return - growth rate)

Finally, the WACC can be determined as follows:

= cost of debt (1 - tax rate) x weight of debt + cost of equity x weight of equity

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