Hi, When using WACC to determine discount rate for new project, what is the market value of debt and market value of equity in the calculation? Is (market value of debt+ market value of equity) = the capital we need to raise for a new project? It is mentioned this is based on company's optimum structure , how does this relate to the calculation? Thanks
Hi Mitsukoshi The market value of debt and equity is the amount of debt and equity capital that is in the business, rather than required for a particular project. So, the MV of equity would be the number of shares x the market price of each share. This means that (MV debt + MV equity) = total capital in the business. The optimal capital structure is an idea that was introduced in CT2 (Chapter 15 is all about the cost of capital). As a business increases the level of debt, initially it will reduce the WACC as they take advantage of the lower cost of debt and tax relief on debt finance. As the amount of debt finance increases, both equity and debt holders will require a higher rate of return. There is a point at which the cost of increasing debt finance begins to outweigh the benefits and the WACC increases. This point represents the optimal capital structure referred to the course notes. Hope this helps Thanks Sarah
