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Expert: Dr. Joseph de Beauchamp — 7/10/2005

Question

Hello Dr. Beauchamp,

As a part of my masters degree, I am currently taking an accounting class. I have some difficulties understanding a couple of terms. Basically, I have been looking at the following valuation sheet of a hypothetical corporation:

Total stockholders’ Equity $ 6,000,000

Total Liabilities and Stockholders’

Net income last year was $1.5 million. The common stock is currently selling for $14.00 per share.

Book value of the corporation $6,000,000 (this is what I came up with)

____________ч________________=________________

The last part is what is causing me confusion. What does it mean to capitalize earnings per share at 20%? Also, what would the phrase Capitalized earning by value per share mean?

Thank you very much for your kind assistance.

Frank Hartmann

Answer

Frank,

I can not tell what you are after here. You need to state your solution with outstanding shares and work from there. I think what you are after is this:

A calculation of a firm’s cost of capital that weights each category of capital proportionately. Included in the WACC calculation are all capital sources, including common stock, preferred stock, bonds, and any other long-term debt.

WACC is calculated by multiplying the cost of each capital component by its proportional weighting and then summing:

Where:

Re = cost of equity

Rd = cost of debt

E = the market value of the firm’s equity

D = the market value of the firm’s debt

V = E + D

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

Tc = the corporate tax rate

Broadly speaking, the assets of a company are financed by either debt or equity. WACC is the average of the cost of each of these sources of financing weighted by their respective usage in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it borrows.

A firm’s WACC is the overall required return on the firm as a whole. It is the appropriate discount rate to use for cash flows similar in risk to the overall firm.

Investors Need A Good WACC — Weighted average cost of capital: difficult to calculate, but a solid way to measure the quality of your investment.

Calculating the WACC — A description of the formula to calculate WACC.

Analytical Process for WACC and Capital Structure — An academic paper by Ruben Cohen on the WACC curve locating the optimal capital structure.

Cost Of Capital — A short article explaining different costs of capital and their measurement.

WACC Curve and Optimal Capital Structure — This is a working Excel file, which underlies the maximum value methodology for producing the WACC curve.