Section outline

  • Module Homepage

  • 1. Introduction

    Welcome to "Cost of Capital and Valuation!" In this module, we learn how to estimate the current value of the cash flows that a firm is expected to generate in the future. This introductory section explains the structure of the module.



    The main learning goals of this module are:
    • Learn what the cost of capital is and how it is affected by financial leverage.
    • Understand the various ways to capitalize free cash flows.
    • Learn how to estimate the Weighted Average Cost of Capital (WACC) in any valuation situation.
    • Learn how to estimate the cost of capital in an international context.
    • Understand the simple mistakes we often make when "unlevering" and "relevering" betas.

    Activities: 2
  • What does capital cost? And how does the presence of debt affect the riskiness of the equity? These are the two major questions we raise in this introductory section.

    Activities: 3
  • This section describes how to bring cash flows and discount rates together to estimate the market value of the firm's assets. To do so, we introduce the two most prominent versions of the discounted cash flow approach: The APV-approach and the WACC-approach.

    Activities: 3
  • This section provides a step-by-step guide to estimating the Weighted Average Cost of Capital (WACC) for listed firms. We discuss how to measure the various ingredients of the WACC in practice and how to put all these estimates together.

    Activities: 3
  • In most valuation situations we have to make some adjustments to the WACC estimates from the previous section. This is generally the case when dealing with privately held firms, when valuing firms that are about to change their financing policy, or when valuing firms that operate in different industries. This section shows the relevant procedures we have to make to correctly estimate the WACC in such specific valuation situations.

    Activities: 5
  • This section shows how to estimate the cost of capital from foreign comparable firms. Very often, this is helpful when operating in countries with a comparatively small domestic market that offers few, if any, listed local firms with similar business activities. 

    Activities: 3
  • In this appendix, we discuss an alternative way to estimate the cost of capital for a firm that changes its capital structure (or has comparables with different financing policies). Instead of unlevering and relevering the cost of capital, we unlever and relever the corresponding betas and then derive the new cost of capital based on the relevered betas. This is the standard approach used in most textbooks and by most practitioners. We show that the two approaches of unlevering and relevering (the cost of capital vs. the betas) are fully consistent. We also show that the simplified equations that most people use to unlever and relever betas substantially bias the resulting WACC estimate. Finally, we provide a simple excel file that allows us to unlever and relever the firm's betas without this bias.

    Activities: 6