0:05

is the weighted average cost of capital.

Â And this is an interesting discussion for me.

Â Remember, we spoke about the Modligiani-Miller approach.

Â And they theorized that investment decisions should be made

Â without regard to where the financing for such investments came from.

Â So what they were saying was,

Â every investment is made from equity in the company.

Â But if you stop and think about it, there is some every investment in equity.

Â Now, we know in after much more corporate financial theory and analysis,

Â that investment and financing decisions, they interact with each other.

Â They can't totally be separated.

Â So that's where we come up with this idea that new concept,

Â it's the weighted average cost of capital.

Â Not the cost of capital, but the weighted average cost of capital.

Â The tax, the after tax, weighted average cost of capital.

Â You remember, M&M, calculated weighted average cost of capital, but

Â they just didn't get any impact for the tax benefit, that you got out of debt.

Â So let's take a look at it, okay?

Â How did the Modigliani-Miller approach work on value and

Â capital investment projects?

Â Well, you forecast your cash flow at the text.

Â Similarly, you're financing through equity.

Â You would then assess the risk of a project,

Â then you would estimate the opportunity cost of capital for the project,

Â calculate NPV using the discount cash flow formula.

Â And essentially, each project would looked that as a mini firm,

Â a kind of a mini company.

Â 1:42

And because we've already talked about the fact that

Â this theory assumes the concept of value-additivity,

Â meaning every project, the enterprise value of a company

Â is equal to the net present value of all of it's assets, okay?

Â Each other task, that's it the additive.

Â That's what we believe.

Â And so that's the way that it was done under M and M.

Â Now, so we're going to talk about

Â 2:12

the value of the financing decision as it relates to investment proposals.

Â And we still continue this principal of value-additivity,

Â meaning, that we still believe that the value of an enterprise is

Â equal to the net present value of its individual assets, okay.

Â But we're now factoring into the calculation,

Â what is the impact of how this thing is financed?

Â Now there's two ways to do this.

Â One is that you adjust the discount rate, typically downward, because

Â what you're doing is, you're accounting for the value of the interest tax shield.

Â Meaning, if a large portion of your corporate capital is

Â provided through debt, the interest you pay on the debt gives you a tax deduction.

Â So essentially you have a tax input.

Â 3:05

It's most common, and it's implemented via the after-tax

Â weighted average cost of capital calculation.

Â So that's one way to do it.

Â The other way to do it is that you adjust the present value by the estimated base

Â case project, assuming that you finance it using equity.

Â And then you adjust it to project the impact on the capital structure.

Â I don't like that approach, it's kind of somewhat complicated and also subject

Â to a lot of kind of assumptions that I don't think are worth dealing with.

Â So I like to look at what and the others [INAUDIBLE] capital.

Â So, if we look at how do you calculate the cost of capital,

Â how Modigliani-Miller did it, they would calculate the data

Â that was cost of capital according to a formula that says r,

Â that's the opportunity cost, equals rd, which means debt, okay.

Â So the opportunity cost of capital equals the D plus E.

Â The opportunity cost of debt, right,

Â times the amount of debt that the company has in its capital

Â structure plus the opportunity cost of equity weighted by

Â the amount of equity that the company has in its capital structure.

Â So, you're essentially saying if I have 80% of my capital as equity and

Â 20% of my capital is debt, and I take the opportunity cost of debt,

Â 20% of it, and 80% of the equity cost and I add them together and

Â that's my weighted average cost of capital.

Â Okay, that ignores a crucial point and

Â that is the interest on the debt that's tax deductible.

Â So now we fix that.

Â We fix it by doing what we call the weighted average cost of capital.

Â We have a new formula, we've adjust this old approach to this more realistic and

Â more reasonable approach.

Â That says this, weighted average cost of capital is the marginal or

Â opportunity cost of debt times 1-Tc.

Â Tc means the marginal tax rate of the company.

Â 5:11

Meaning, what is the tax benefit, what's the actual tax

Â benefit of the debt interest that your income generating.

Â And that, because you're doing that, if you look at the way the calculation works,

Â you're taking some percentage.

Â Something less than 1, right?

Â And so you're multiplying that times the debt of percentage.

Â And that results in an overall lower Weighted Average Cost of

Â Capital because the opportunity cost of capital, sorry,

Â the Weighted Average Cost of Capital is lower than r,

Â the opportunity cost of capital, because the cost debt is after-tax.

Â Reflecting with tax advantages of debt in the Weighted Average Cost of Capital.

Â I hope that makes sense.

Â I need to say that again.

Â The old method let's say, the old method of calculating the r,

Â that's Modigliani method that you'll be more interest.

Â That number is going to be higher than the weighted average cost of

Â capital because of the impact of interest lowers that cost down.

Â So that's important to understand, okay.

Â So the weighted average cost of capital reflects

Â the after-tax benefit of debt In the capital structure and

Â the variables are considered for the firm as a whole, okay?

Â So you're looking at your calculating this as the firm as a whole.

Â So in a perfect world, only projects that are exactly like the firm.

Â In every way there's just calculation worked best.

Â But in reality, nothing is perfect so

Â it works with the kind of the average project.

Â So people have decided that we're going to need [INAUDIBLE] source of capital.

Â Now, if for example you were going to have a project that it is much lesser risky or

Â much more risky than the average of projects that the firm had done.

Â Because the average risk of the firm will reflect that

Â debt versus equity out the way.

Â So it would be incorrect to use weighted average cost capital if you had a project

Â that was so different than the firm itself.

Â 7:33

And it's also incorrect to use the way that cost of capital if the project itself

Â will result in a substantive change and the debt to equity ratio of the company.

Â Now I don't have an example of projects that might do that, I could,

Â I do actually have an example.

Â Let's say a company like the Kennedy Center is building a huge

Â parking garage and they're issuing debt to do that, okay?

Â If the Kennedy Center doesn't have a significant amount of debt and suddenly,

Â now keep in mind they're a non-profit, but let's just assume they're not, okay.

Â They're issuing a huge amount of debt.

Â Suddenly they have a different debt/equity ratio.

Â So that would be incorrect to use the weighted average cost of capital

Â in evaluating that project.

Â That's a common example of that.

Â So as a corporate entrepreneur,

Â you've heard all these things about valuation technique.

Â 8:23

I don't think you're going to ever be expected or

Â required to do these calculations that we've just gone through.

Â I think that somebody else in the relation will in fact do that.

Â Your corporate finance group will do it or

Â in mobile it was called the Corporate Planning Department,

Â planning that the group be allocated all capital budget across all.

Â They do the calculation.

Â But you need to know how they work.

Â You need to understand what to expect.

Â You need to understand what they're going to generate so that when you

Â presented to the corporate financiers or the corporate planning group,

Â you will understand what they should expect to see and if they come back with

Â a number which still makes [INAUDIBLE] you should be able challenge that okay.

Â It enables you to ask kind of better questions, challenge the assumptions.

Â You're better prepared to discuss your project and

Â the financial implications it has on the corporation.

Â And you see them advocate for your own ideas in a financial way,

Â even though you're not really a financial person.

Â So, I hope this has been useful information and

Â so this kind of wraps up our evaluation discussion and I'll see you next time.

Â We'll go to module here.

Â