WACC – Simpler Than It Seems

Don’t skim over this formula.  Understanding how to arrive at the final measurement of WACC will help when you immensely in understanding the more complicated facets of corporate finance and portfolio management.

So, here’s the formula:

WACC = [ (D/V) * r_d * (1-t) ] + [ (E/V) * r_e ]

D = Market value of Debt

E = Market value of Equity

V = Total Value ( D + E )

r_d = Cost of Debt (the return demanded for purchasing issuer’s debt)

r_e = Cost of Equity (the return demanded for purchasing issuer’s equity)

t = Tax rate

Rather than just memorizing where to place each variable, breaking this formula down to its basic elements before applying them to the problem at hand will make solving the problem seem almost natural.

Bond Pricing, Clean and Dirty

Bond valuation is achieved through a series of Discounted Cash Flow (DCF) calculations. With bonds requiring multiple coupon payments, you have 2 options.

You can discount each payment individually to the bond’s origin, discounting the T10 payment over 10 periods to T0, then discounting the T9 payment over 9 periods to reach T0, and continuing to do so until you have the present value of each payment to be made over the life of bond. Finally, add these discounted payments together to arrive at the value of the full bond agreement.

The second option is to discount the payment to be made at T10 to T9, add that discounted payment to the original T9 payment, then discount that sum to T8, continuing until you reach T0, with all payments already accounted for.

(There are a few factors that contribute to the discount you would apply to future cash flows, but assume a static premium of 6% is charged per year to compensate lenders for their patience and willingness to bear the risk of non-payment)

Fiscal and Monetary Policy

Aren’t they the same thing?

As with everything else in finance, almost, but no.

Monetary policies are enacted by central banks [such as the United States’ Federal Reserve] in attempts to stimulate or soften the growth of the nation’s economy. This is generally achieved through changes in interest rates, reserve requirements, and the supply of money.

Fiscal policy is in the hands of the federal government, where tax rates and aggregate government expenditures are constantly modified to act as a throttle on economic expansion.

Expand, Contract, Repeat…

The economic state of a nation is ever-changing, and the use of fiscal and monetary policy allows governing bodies the ability to tilt the scales in the hopes of maintaining balance or avoiding catastrophe.

Calculating CFO, CFI, and CFF

It’s important to remember that CFO, CFI, and CFF add up to Net Cash Flow

So assume you’re given the following information regarding the cash flows of a manufacturing firm for the year:

Action	Cash Flow
Purchase inventory	(200,000)
Pay Salaries	(600,000)
Issue Debt	1,800,000
Sales(cash collected)	1,300,000
Pay Interest on Debt	(16,000)
Purchase Assets	(750,000)
Equity Share Buyback	(300,000)
Pay Taxes	(125,000)
Pay Dividend	(25,000)
Collect on Accounts Receivable	75,000
Settle Accounts Payable	(125,000)
Net Cash Flow	1,034,000

Let’s see if we can separate these cash flows accordingly.