When valuing a firm, the appropriate discount rate is the firm’s weighted average cost of capital – the return required by the firm’s “typical” investor.Â Since debtholders typically have a greater claim on the firm’s assets they typically require less of a return. Equity holders have a residual claim and require a greater return on the funds they invest.
In addition, firms are typically able to deductÂ interest payments from income for tax purposes, but are not generally permitted to deduct payments to equity holders.
The weighted average cost of capital (WACC) can be calculated as: [(percentage of financing that is debt)X(after tax interest rate)] + [(percentage of financing that is equity) X (required return on equity)]
For example, a firm with total capital of $1 million, of which $400,000 is debt paying a 6% coupon. The firm’s tax rate is 40% and its equity holders require a 10% return.
WACC = 0.4(0.06 * (1 – 0.40)) + 0.6(0.10) = 0.4(0.36) + 0.06 = 0.0744 = 7.44%.For more information, see all articles on: Valuation See also: