WACC

• Redeemable debt is calculated as Kd = I / PV, where Kd is the cost of debt (after tax), I is the interest cash flow (after tax), and PV is the market value.
• Debt exposes the company to financial risk.
• Dividends are not deductible for tax purposes regardless of whether the preference shares are classified as debt/equity.
• If the cost of debt (Kd) is given, the market value (PV) should be calculated.
• The cash flow function on a calculator can always be used to calculate the cost of debt (Kd) if the current market value (PV) is given.
• Non-redeemable debt is calculated as PV = I / Kd, where PV is the market value of debt, I is the interest cash flow (after tax), and Kd is the cost of debt (after tax).
• A loan which requires repayment would also be classified as redeemable debt.
• Interest is deductible for tax purposes.
• If the current market value (PV) is given, the cost of debt (Kd) should be calculated.
• The discount rate when calculating the market value of debt should be the market-related rate/fair rate/rate on similar debt instruments (Kd).
• The coupon rate should be used to calculate the interest cash flow.
• The cash flow function on a calculator can only be used if the annual cash flows (PMT) are equal.
• The market-related rate/fair rate/rate on similar debt instruments (Kd) is the current/ruling market rate of return obtained from similar publicly traded instruments.
• A loan which does not require repayment would also be classified as non-redeemable debt.
• The weighted average cost of capital (WACC) represents the return that a company needs to achieve in order to fully compensate the debt and equity providers, it is the cost to finance the company.
• After the optimal level of debt, any further increase in debt will increase financial risk and the shareholders will demand a higher return causing the WACC to increase.
• The traditional theory should be followed, stating that the optimal capital structure is the point where the WACC is minimised and the company value is maximised.
• The Traditional Theory states that as debt increases, the WACC will decrease as debt is cheaper than equity, and initial increases in debt do not increase the overall risk of the company, therefore the shareholders required rate of return (Ke) will not increase initially.
• Capital investment appraisal, valuations, and Economic Value Added (EVA) are uses of the weighted average cost of capital (WACC).
• Debt is cheaper than equity and can therefore be used to improve returns to shareholders.
• The value of a company is determined by its assets and not the manner in which those assets are financed, according to the Miller and Modigliani Theory.
• The optimal capital structure is where the WACC is at its lowest, as this is the point where the company value is maximised.
• The Miller and Modigliani Theory states that as debt increases, the WACC will decrease as debt is cheaper than equity, and shareholders will demand a higher return (Ke) causing the WACC to increase.
• The cost of capital for the company is merely a mirror image of the return required by the investor, interest paid by the company equals interest received by the investor, and dividends paid by the company equals dividends received by the investor.
• The cost of capital is the return required by shareholders.
• The cost of capital is the sum of business risk and financial risk.
• Business risk is the risk that relates to the operating activities of the company.
• Financial risk is the risk that relates to the level of debt within the company.
• Shareholders required return (Ke) = Business risk + Financial risk.
• Bank overdrafts should only be included in the WACC calculation if used as long-term capital and not to finance working capital.
• If a bank overdraft is provided for working capital purposes, it should be excluded from the WACC calculation.
• Only include long-term/permanent sources of capital in the WACC calculation.
• The total weighting in the WACC calculation should add up to 100%.
• The WACC includes the effect of inflation.
• Capital structure is the mix of debt and equity in financing the assets of the company.
• Debt: Equity ratio = Non-current liabilities / Equity or = Non-current liabilities : Equity.
• The market value of equity is calculated using the number of shares in issue and not the authorised number of shares.
• Gordon’s dividend growth model is calculated as PV = D1 / ( Ke - g)  Ke = D1/PV + g.
• If β < 1, the company’s share price is less volatile than the market.
• The cost of equity can be calculated using Gordon’s dividend growth model or the capital asset pricing model.