Estimating the Cost of Capital
In order to discount the free cash flows to the firm in the DCF valuation model, you need to compute the weighted average cost of capital (rwAcc). It is defined as the weighted average of the costs of different components of financing used by the firm:
rwacc = E/(E+D)rE + D/(E+D)rD(1 - τc)
where E is the market value of equity. D. the market value of debt. rε. the cost of equity capital. rD, the cost of debt capital. and τc, is the marginal tax rate. We adjust the cost of debt capital for the tax deductibility of interest payments to accord with the after-tax free cash flows to be discounted. The cost of debt reflects the current yields on the outstanding debt of the firm making adjustments for the default risk of the company. Often adjustments for default risk use bond ratings in conjunction with the probabilities of default from ratings agencies. such as Moody's and S&P. (Information is available in Chapter 12 of Berk and DeMarzo). The cost of equity capital is computed using historical information on stock returns in conjunction with the CAPM. The past five years of daily data from Assignment #1 with the S&P 500 or S&P/fSX as market portfolio proxy should suffice. but double-check your calculations with market betas from commercial services (See Week 4 Lecture 4.2 for details with a spreadsheet example using monthly data). Are the betas comparable to those of the firm's peer competitors (remember to =lever the betas before you make fair comparisons). You may also want to adjust the betas for any important changes that you anticipate may affect the business or financial risks of the firm. Use information from Part 2 above to guide you on what the appropriate capital structure weightings are for the computation.
Attachment:- financials.zip