LOS h: Explain and calculate the weighted average cost of capital for a company.

Q1. Jaime Moreno, a new hire at the venture-capital fund Burkhart Partners, has been tasked with assessing the appeal of various potential equity investments. Moreno has been given the weighted average cost of capital (WACC) for each company. To determine the value of each company’s equity, Moreno should:

A)   strip the effects of debt out of the WACC, then calculate the value of equity.

B)   calculate the firm value using the WACC, then strip out the value of debt.

C)   calculate the equity value using the WACC, then incorporate the value of debt.

Q2. For an analyst seeking to value an entire company, the best tool is the:

A)   capital asset pricing model.

B)   weighted average cost of capital.

C)   Pastor-Stambaugh model.

Q3. Marina Syltus, chief financial officer of Worcester Water Treatment, wants to know the cost of the company’s capital so it can make wiser budgeting decisions. Syltus has assembled the following data:

• Worcester’s long-term debt has a market value of $230 million.
• Worcester’s shares have a total market value of $782 million.
• The marginal tax rate is 37%.
• The required return on equity is 14.6%.
• Worcester’s long-term debt has a weighted average interest rate of 9.4%.

To calculate the weighted average cost of capital, Syltus needs:

A)   the required return on debt.

B)   the target debt/equity ratio.

C)   both the required return on debt and the target debt/equity ratio.

LOS h: Explain and calculate the weighted average cost of capital for a company. fficeffice" />

Q1. Jaime Moreno, a new hire at the venture-capital fund Burkhart Partners, has been tasked with assessing the appeal of various potential equity investments. ffice:smarttags" />Moreno has been given the weighted average cost of capital (WACC) for each company. To determine the value of each company’s equity, Moreno should:

A)   strip the effects of debt out of the WACC, then calculate the value of equity.

B)   calculate the firm value using the WACC, then strip out the value of debt.

C)   calculate the equity value using the WACC, then incorporate the value of debt.

Correct answer is B)

WACC is used to value an entire firm. To value the equity, use the WACC to calculate the firm’s value, then subtract the market value of its long-term debt.

Q2. For an analyst seeking to value an entire company, the best tool is the:

A)   capital asset pricing model.

B)   weighted average cost of capital.

C)   Pastor-Stambaugh model.

Correct answer is B)

The capital asset pricing model and Pastor-Stambaugh models are used to calculate the required return on equity. The weighted average cost of capital is used to value an entire company.

Q3. Marina Syltus, chief financial officer of Worcester Water Treatment, wants to know the cost of the company’s capital so it can make wiser budgeting decisions. Syltus has assembled the following data:

• Worcester’s long-term debt has a market value of $230 million.
• Worcester’s shares have a total market value of $782 million.
• The marginal tax rate is 37%.
• The required return on equity is 14.6%.
• Worcester’s long-term debt has a weighted average interest rate of 9.4%.

To calculate the weighted average cost of capital, Syltus needs:

A)   the required return on debt.

B)   the target debt/equity ratio.

C)   both the required return on debt and the target debt/equity ratio.

Correct answer is C)

The equation for the weighted average cost of capital is as follows:

Market value of debt / market value of debt and equity × required return on debt × (1 ? tax rate) + market value of equity / market value of debt and equity × required return on equity.

As such, we need the required return on debt to determine the WACC. However, analysts normally assume debt and equity are at their target ratio to calculate the cost of capital. If the current capital allocation does not match the target weighting, we use the target weighting. Thus, we also need the target weights for debt and equity, which we can derive from a target debt/equity ratio.

LOS h: Explain and calculate the weighted average cost of capital for a company. fficeffice" />

Q1. Jaime Moreno, a new hire at the venture-capital fund Burkhart Partners, has been tasked with assessing the appeal of various potential equity investments. ffice:smarttags" />Moreno has been given the weighted average cost of capital (WACC) for each company. To determine the value of each company’s equity, Moreno should:

A)   strip the effects of debt out of the WACC, then calculate the value of equity.

B)   calculate the firm value using the WACC, then strip out the value of debt.

C)   calculate the equity value using the WACC, then incorporate the value of debt.

Correct answer is B)

WACC is used to value an entire firm. To value the equity, use the WACC to calculate the firm’s value, then subtract the market value of its long-term debt.

Q2. For an analyst seeking to value an entire company, the best tool is the:

A)   capital asset pricing model.

B)   weighted average cost of capital.

C)   Pastor-Stambaugh model.

Correct answer is B)

The capital asset pricing model and Pastor-Stambaugh models are used to calculate the required return on equity. The weighted average cost of capital is used to value an entire company.

Q3. Marina Syltus, chief financial officer of Worcester Water Treatment, wants to know the cost of the company’s capital so it can make wiser budgeting decisions. Syltus has assembled the following data:

• Worcester’s long-term debt has a market value of $230 million.
• Worcester’s shares have a total market value of $782 million.
• The marginal tax rate is 37%.
• The required return on equity is 14.6%.
• Worcester’s long-term debt has a weighted average interest rate of 9.4%.

To calculate the weighted average cost of capital, Syltus needs:

A)   the required return on debt.

B)   the target debt/equity ratio.

C)   both the required return on debt and the target debt/equity ratio.

Correct answer is C)

The equation for the weighted average cost of capital is as follows:

Market value of debt / market value of debt and equity × required return on debt × (1 ? tax rate) + market value of equity / market value of debt and equity × required return on equity.

As such, we need the required return on debt to determine the WACC. However, analysts normally assume debt and equity are at their target ratio to calculate the cost of capital. If the current capital allocation does not match the target weighting, we use the target weighting. Thus, we also need the target weights for debt and equity, which we can derive from a target debt/equity ratio.

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