Question

In the previous Module (Investment Tools) we were given the cash flows and the discount rates, and we had to solve for IRR, NPV, MIRR, PayBack, or whatever

In this Module, we have to figure out the cash flows for ourselves and put them through the tools of the last Module. But the rate we used was still given to us.

So, while it is safe to assume that at some point before the end of the semester, we will have to figure out what discount rate to use, How do we come up with that rate, the "appropriate Risk Adjusted discount rate?"

We have not looked at "risk free" projects, so that is not the rate.

We are not investing in the Market as a whole, so we are not going to use the "Market rate of return."

So, who sets the rate we should use, how and why? From where does it come?

Answer 1

The appropriate discount rate will differ for each security, as every security has a unique set of risks associated with it

The Weighted Average Cost of Capital (WACC), is the discount rate that we will use to discount the cash flows

WACC is composed of 2 components

1) Cost of Equity

2) Cost of Debt

Cost of Equity

Is caluclated by the CAPM Model, where

Cost of Equity = Risk Free Rate + Beta ( Average rate of return of Market - Risk free Rate)

Cost of Debt

The average cost of debt for all interest bearing debt obligations, will Serve as our cost of debt

Now to summarize it

WACC = Cost of Debt * (1 - Tax Rate ) * Weight of Debt + Cost of Equity * Weight of Equity

This is the appropriate discount rate for each investment