Financial Valuation Methods and Cost of Capital

Present Value Calculation

Present Value Calculation: The present value method has multiple applications in finance and refers to today’s value for a stream of future cash flows. Positive cash flows are called cash inflows and negative cash flows are called cash outflows.

The present value (PV) formula can be written as follows:

Where k is the discount rate and the expression is called the discount factor.

Net Present Value (NPV)

Net Present Value: It is defined as the difference between the present value of the future cash flows generated by the investment and the initial cash outlay.

Internal Rate of Return (IRR)

IRR: It is defined as the discount rate that makes the present value of future cash flows equal to the initial investment outlay. The IRR is the discount rate that produces a net present value of zero.

IRR Limitations

• Lending or borrowing
• Multiple rates of return

Concept of Cost of Capital

The cost of capital is the weighted average of the costs of different sources of financing used by a company to fund its investments. It is also known as WACC, which stands for Weighted Average Cost of Capital. WACC is a key concept to evaluate investment decisions since a project is accepted if its profitability is higher than the necessary cost to finance it, creating value for the firm in this way.

We are going to use the following terminology:

• V: Market value of the company
• D: Market value of debt
• E: Market value of equity
• D: Cost of issuing new debt
• E: Cost of common equity
• T: Corporate tax rate

Cost of Equity

Equity, in general, is the amount of funds contributed by the company's owners plus retained earnings minus accumulated losses. The cost of equity is the rate of return demanded by the shareholders to invest in the equity of a firm.

It can be estimated by using one of the following approaches:

1. The Capital Asset Pricing Model (CAPM)
2. The Dividend Discount Model

Cost of Debt

The cost of debt refers to the cost of borrowings to finance projects. The after-tax cost of debt is the interest rate at which firms can issue new debt, taking into account the tax savings from the tax deductibility of interest.

After-tax cost of debt = Pre-tax cost of debt (1 - Corporate tax rate)

After-tax cost of debt = rD (1 - t)

Weighted Average Cost of Capital (WACC)

WACC is generally calculated using market values of debt and equity, but in the case of debt, book values are also used. The market value of equity is the number of shares multiplied by the current share price.

Difference Between Debt and Equity

The distinction between debt and equity is related to the cash flow claims of each kind of financing source. The main differences are the following:

• Debt: Entitles the holder to receive a stream of cash flows, usually interest and principal payments.
• Equity: Entitles the holder to receive discretionary dividends and to get the shares' market value when the security is sold.