# Chapter 16 : Cost of Capital and Discounting Cash Flows

Returns matter a lot. It's our Capital.

Abigail Johnson

All the cash flows forecasted have to be discounted back to obtain the present value. For that, we need a discount rate. I use the Weighted Average Cost of Capital (WACC). Weighted Average cost of Capital is the weighted average cost of debt and equity capital. It may also be called the Cost of Capital.

For example, if a company's pre-tax cost of debt is 10%, estimated cost of equity is 15%, income tax rate is 30%, and it finances its business growth by debt of 40% and equity of 60%, then the weighted averages cost of capital would be computed as follows:

 Particulars Weight (%) Cost (%) Weighted Cost (%) Debt (After Tax) 40 7 2.8 Equity 60 15 9.0 Cost of Capital 11.8

Notes:

1. Post tax cost of debt equals cost of debt x (1- tax rate) = 10% x (1 - 30%) = 7%
2. Cost of capital is also called Weighted Average Cost of Capital (WACC)

### Example of Black Bay Pizza for Computing WACC / Cost of Capital

Continuing with the example of Black Bay Pizza, we now compute the cost of capital for Black Bay Pizza in Table 11 based on the following assumptions:

Assumptions

 Market Capitalization 3000 Debt 1000 Post Tax Cost of Debt x (1- tax rate)8% x (1 - 25%) 6% Cost of Equity (Refer Chapter 15) 10.5%

Table 11 - Computation of WACC (Cost of Capital)

 Particulars Weight Cost Weight Cost Debt - Post Tax 1000 25% 6% 1.5% Equity 3000 75% 10.5% 7.87% Cost of Capital / WACC 4000 100% 9.37%

Thus based on the above computation, the cost of capital or WACC comes to 9.37%

### Discounting Cash Flows

In Table 12, we discount the cash flows of Black Bay Pizza presented in Table 7 with cost of capital (WACC) computed above to arrive at the present value of cash flows during the forecast period.

Table 12

 Net Cash Flow 32 37 76 111 125 Discount Factor 1 0.914 0.836 0.764 0.699 0.639 PV of Cash Flows 29.1 30.6 58.4 77.6 79.7 Cumulative PV of Cash Flows 29 60 118 196 276 Inflation 5% WACC 9.37%

The cumulative present value of cash flows for the forecast period is 276.

Use the Weighted Average Cost of Capital (WACC) which is the weighted average cost of debt and equity capital to discount the cash flows.