Chapter 16 : Cost of Capital and Discounting Cash Flows

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:

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

Table 11 - Computation of WACC (Cost of Capital)

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

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