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is the weighted average cost of capital.

And this is an interesting discussion for me.

Remember, we spoke about the Modligiani-Miller approach.

And they theorized that investment decisions should be made

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

So what they were saying was,

every investment is made from equity in the company.

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

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

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

They can't totally be separated.

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

it's the weighted average cost of capital.

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

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

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

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

So let's take a look at it, okay?

How did the Modigliani-Miller approach work on value and

capital investment projects?

Well, you forecast your cash flow at the text.

Similarly, you're financing through equity.

You would then assess the risk of a project,

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

calculate NPV using the discount cash flow formula.

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

a kind of a mini company.

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And because we've already talked about the fact that

this theory assumes the concept of value-additivity,

meaning every project, the enterprise value of a company

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

Each other task, that's it the additive.

That's what we believe.

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

Now, so we're going to talk about

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

And we still continue this principal of value-additivity,

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

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

But we're now factoring into the calculation,

what is the impact of how this thing is financed?

Now there's two ways to do this.

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

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

Meaning, if a large portion of your corporate capital is

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

So essentially you have a tax input.

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

weighted average cost of capital calculation.

So that's one way to do it.

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

case project, assuming that you finance it using equity.

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

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

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

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

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

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

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

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

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

The opportunity cost of debt, right,

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

structure plus the opportunity cost of equity weighted by

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

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

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

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

that's my weighted average cost of capital.

Okay, that ignores a crucial point and

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

So now we fix that.

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

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

more reasonable approach.

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

opportunity cost of debt times 1-Tc.

Tc means the marginal tax rate of the company.

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

benefit of the debt interest that your income generating.

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

you're taking some percentage.

Something less than 1, right?

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

And that results in an overall lower Weighted Average Cost of

Capital because the opportunity cost of capital, sorry,

the Weighted Average Cost of Capital is lower than r,

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

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

I hope that makes sense.

I need to say that again.

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

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

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

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

So that's important to understand, okay.

So the weighted average cost of capital reflects

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

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

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

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

In every way there's just calculation worked best.

But in reality, nothing is perfect so

it works with the kind of the average project.

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

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

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

Because the average risk of the firm will reflect that

debt versus equity out the way.

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

that was so different than the firm itself.

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

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

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

I do actually have an example.

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

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

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

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

They're issuing a huge amount of debt.

Suddenly they have a different debt/equity ratio.

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

in evaluating that project.

That's a common example of that.

So as a corporate entrepreneur,

you've heard all these things about valuation technique.

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

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

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

Your corporate finance group will do it or

in mobile it was called the Corporate Planning Department,

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

They do the calculation.

But you need to know how they work.

You need to understand what to expect.

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

presented to the corporate financiers or the corporate planning group,

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

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

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

You're better prepared to discuss your project and

the financial implications it has on the corporation.

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

even though you're not really a financial person.

So, I hope this has been useful information and

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

We'll go to module here.