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1.6 Discount Rates

Once the numerators in Equation 1 are calculated, all that is needed to do a valuation is to calculate the denominators in Equation 1. This is the goal of Chapter 5, “Cost of Capital.” Calculating this cost of capital (or equivalently, the required/expected rate of return)6 for a project is actually a difficult task, and one that the field of finance is still heavily researching. As a result, there is no universally agreed-upon methodology for doing these calculations.7 Chapter 5 presents a couple of the basic theories for determining the cost of capital and then also shows a couple of methods that are used in practice. Regardless of how one chooses to calculate a cost of capital, the procedure for decomposition of this value into other cost of capital values, such as cost of debt capital and cost of equity capital, is universally agreed upon, and this is what we cover next in Chapter 5. Included in this discussion is a measure called the asset cost of capital.

The discussion of these topics naturally brings up the question of how capital structure affects the expected return of the left-hand side of the balance sheet. It is at this point that we will discuss the implications of financing choices such as tax shields and costs of financial distress. As shown in Figure 1.5, these financing implications alter the value of the left-hand side of the balance sheet (and consequently the right-hand side as well), which in turn affects cost of capital calculations. Therefore, an important part of the discussion in Chapter 5 is the procedure for calculating the cost of capital taking into account the effects of capital structure decisions.

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Figure 1.5 Implications of financing choices

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