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MV of equity is used in WACC which is calculated using free cash flows.
On the other hand MV of equity is calculated by multiplying no. of shares with share price i.e. market capitalization and this vaue is used in calculating WACC.
and in turn share price is calculated by dividing value of firm (not just value of equity) by number of shares.
it means market capitalization=value of the firm and is used in WACC calculation.
how can then MV of equity be used in WACC calculation instead of MV of firm?Share price is not calculated by dividing the value of the firm by the number of shares.
It is calculated by dividing the total market value of equity by the number of shares.
It would make no sense to do different and he has not done different in his answer to Coeden.The WACC is calculated by weighting the cost of equity by the market value of equity, and the cost of debt by the market value of debt.
Ok but what does a share price represent ?
Does it not represent the value of whole company ?
what if a hypothetical firm has 500 shares in issue each trading at $ 5.
in addition to it, it has $ 200 worth loan.
So if I acquire company by its market cap i.e. 2500 then what happens to debt ?
definitely i will have to acquire it along with company. As it is reflected in the share price of the company.
so if we divide value of firm by number of shares then what do we get ?
Aint the debt reflected in share price of the firm ?Think of it this way.
Suppose first we have a company that it all equity financed. The value of the shares is (in theory) determined by the present value of the company’s cash flows. Suppose this comes to $2500. If there are 1000 shares then the market value per share is $2.50.
Suppose we have exactly the same company, where $200 of the finance comes from long-term debt. The value of the whole business will still be $2500 (because the free cash flows are the same if it is the same company). However, because $200 of it comes from debt, the market value of the shares will be $2300 and the mkt value per share will be $2.30.
To get the market value of the shares, there are two approaches – either we use free cash flows discounted at the WACC to get the market value of the whole business and then subtract the long-term debt (as above).
Or alternatively, we use the free cash flows to equity (which will be lower because of the interest payments on the debt) and discount these at the cost of equity – this will give the market value of the equity alone.I would like to answer his question like this.. The hypothetical question is, if there are 500 shares and the market price per share is $5, then of course the company is worth $2500. But there is a debt of $200. So if I want to buy the company I will have to buy all the 500 shares and so I will have to pay $2500. No doubt about it. But you will also have to take the debt.
You must view it like this. The share price of $5 has taken into consideration the debt. Or in another words if the debt is not there the share price would have been more than $5.
Dear sir, with the reference to the same above question, I would like to know how .769 and .231 came when calculating cost of capital. I am sure I am missing something. Could you please rectify me how those figures are coming.
Thanks a lot
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