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We're going to be running some numbers in the next section, but

even to think about the components of the cost of capital,

the best thing is to get the notation out of the way.

So, we can talk in terms of notation and

everybody knows what we're really are talking about.

So, we're going to think as we said before.

On the most typical task.

On a company that is financed by debt and by equity, and

as we said before there are companies that are only fully financed by equity.

Well that notation would be contained, in what we are going to discuss, and

there are companies that are actually financed by more sources of financing.

And, and again as we said before and

we'll probably highlight that again a little bit later.

You only need more terms that have the same structure,

as the terms that we're going to discuss.

So for all our practical purposes data and equity.

And the two terms that we're going to be dealing with,

are far more than, than enough.

So.

That's the expression that we're going to use to calculate the weighted average cost

of capital, and let me start on the left-hand side.

The left-hand side you se R what?

Many times, more often than not,

I'd probably admit, you actually see only what on the left hand side?

The reason I want to put a R before the what,

is to remind you at the end of the day this is a required return.

And required returns are always related to risk.

So, you know, you can take the R out if you don't like it and

just leave the WACC part.

The notation that I'm going to use keeps the R and again,

keeps the R just to remind you that this is a required return.

On the capital invested.

So, the RWACC that we're going to have on

the left-hand side is basically the weighted average cost of capital or

the cost of capital that we want to estimate.

What's on the right-hand side?

Well, on the right-hand side as you see there are two terms.

One term is for debt, and one terms is for equity.

And by terms I mean, one thing on the left-hand side of the plus sign, and

one thing on the right-hand side of the plus sign.

Now what is on the left-hand side of the, the less sign?

Well, let's take it the other way around.

Instead of thinking of debt and

equity, let's think in terms of, the, the terms that we have.

In that WACC.

Everything that is an R, again and it's just that you

need to keep this in the back of your mind, is a required return.

So we said on the left-hand side, this is a required return on the capital

investment, well but as you see, there's two Rs on the right-hand side.

There's Rd and there's Re.

Generally, d stands for debt and e stands for equity.

That's the way we typically use the notation in corporate finance,

which means that Rd and Re, are the required return on debt and

the required return on the equity.

So everything that has an R is a required return.

As it will become more clear as the discussion goes by, everything that

is a required returned is related to the risk perceived by investors,

that provide that particular source of capital.

So, for as far as a notation goes, Rd is going to be the required return on debt,

Re is going to be required return on equity, and sometimes you can

see people referring to these simply as the cost of debt and the cost of equity.

So, we're going to be using those terms interchangeably.

The required return on debt, on the cost of debt.

And the required return on equity, and

the cost of equity, all these things are going to be denoted by Rd and Re.

Them come the, then comes the corporate tax rate.

You know, the, the, the, the, we have to pay taxes on a personal level.

Corporations have to pay taxes.

And there's no getting away from that.

Some corporations pay more.

Some corporations pay less.

But at the end of the day, there is what we call a corporate tax rate.

This is what presumably, corporations would actually have to pay.

Of course, you know, some corporations may have to pay more,

because there are state taxes, and municipal taxes, and so forth.

Some corporations pay less, because they get all sorts of tax breaks and

all sorts of ways of reducing.

Not the taxes that they have to pay, but

the recent corporate tax rate that we're going to denote as TC.

A, and that TC you're seeing there is simply the notation for

the corporate tax rate.

And it's going to become important for the following reason.

And we're going to see an example.

A little bit later on.

It's going to become important because,

in just about every tax code in the world there's an asymmetry.

And the asymmetry means that, the following.

That when you pay interest on the debt, you do that before taxes.

But when you pay dividends, you do that after taxes.

What is the meaning of that?

Well, it means that when you pay your dollar of interest, that

actually reduces your profits and that means that you pay, you pay less taxes.

However, when you pay, a dollar of dividends, you do it after taxes.

Which means that it's an actual dollar.

So in the first case,

the dollar that you pay you're really effectively paying a little bit less.

Because you get a little bit of a tax break, which we're going to quantify.

A couple of minutes from now.

So basically when you pay $1 of interest and

$1 of dividends, the $1 of dividends is just a net dollar of dividends.

But that $1 of interest you need to account for

the fact that you get a tax break on that.

And so we can actually calculate, the after tax cost of debt.

And by after tax we mean taking into account that tax break, that tax shelter

that we get, when we have debt as opposed to equity in the capital structure.

So the notation that you see there, one minus tc multiplied by RD.

That's what we're going to call, the after tax cost of debt.

After taking into account that when we pay interest on the debt,

we get a tax break on that debt.

We're going to see a numerical example in a minute.

And this will become much more clear than it is now.

Again we're only defining notation at this point.

And that notation is TC, is going to be the corporate Tax rate,

and 1 minus TC multiplied by Rd is going to be the after-tax cost of them.

Finally the, the proportions,

again remember that's why we call it a weighted average cost of capital.

We need to take into account, how much we're using, in relative terms,

in this case, of debt and equity.

And, and we do that in a very simple way.

First we, we add up all the debt and all the equity that we have.

And that's what some people would call the capital invested,

the capital that we have to invest in long term projects.

And then we calculate, simply, the proportion D divided by the sum of D plus

E, as you see that we are going to call Xd, and E divided by the sum of D plus E,

as you see there also, that's what we're going to call Xe.

So, XD and xE are the proportions of debt and equity.

That a company's using to finance their investment activities.

Now there's one important thing here.

The, and this is just a side comment because again this is not one of

the issues that we're going to explore.

But the issue of capital structure is all about

determining the optimal proportions of xD and xE.

In other words you want to find.