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Â We're going to be running some numbers in the next section, but

Â even to think about the components of the cost of capital,

Â the best thing is to get the notation out of the way.

Â So, we can talk in terms of notation and

Â everybody knows what we're really are talking about.

Â So, we're going to think as we said before.

Â On the most typical task.

Â On a company that is financed by debt and by equity, and

Â as we said before there are companies that are only fully financed by equity.

Â Well that notation would be contained, in what we are going to discuss, and

Â there are companies that are actually financed by more sources of financing.

Â And, and again as we said before and

Â we'll probably highlight that again a little bit later.

Â You only need more terms that have the same structure,

Â as the terms that we're going to discuss.

Â So for all our practical purposes data and equity.

Â And the two terms that we're going to be dealing with,

Â are far more than, than enough.

Â So.

Â That's the expression that we're going to use to calculate the weighted average cost

Â of capital, and let me start on the left-hand side.

Â The left-hand side you se R what?

Â Many times, more often than not,

Â I'd probably admit, you actually see only what on the left hand side?

Â The reason I want to put a R before the what,

Â is to remind you at the end of the day this is a required return.

Â And required returns are always related to risk.

Â So, you know, you can take the R out if you don't like it and

Â just leave the WACC part.

Â The notation that I'm going to use keeps the R and again,

Â keeps the R just to remind you that this is a required return.

Â On the capital invested.

Â So, the RWACC that we're going to have on

Â the left-hand side is basically the weighted average cost of capital or

Â the cost of capital that we want to estimate.

Â What's on the right-hand side?

Â Well, on the right-hand side as you see there are two terms.

Â One term is for debt, and one terms is for equity.

Â And by terms I mean, one thing on the left-hand side of the plus sign, and

Â one thing on the right-hand side of the plus sign.

Â Now what is on the left-hand side of the, the less sign?

Â Well, let's take it the other way around.

Â Instead of thinking of debt and

Â equity, let's think in terms of, the, the terms that we have.

Â In that WACC.

Â Everything that is an R, again and it's just that you

Â need to keep this in the back of your mind, is a required return.

Â So we said on the left-hand side, this is a required return on the capital

Â investment, well but as you see, there's two Rs on the right-hand side.

Â There's Rd and there's Re.

Â Generally, d stands for debt and e stands for equity.

Â That's the way we typically use the notation in corporate finance,

Â which means that Rd and Re, are the required return on debt and

Â the required return on the equity.

Â So everything that has an R is a required return.

Â As it will become more clear as the discussion goes by, everything that

Â is a required returned is related to the risk perceived by investors,

Â that provide that particular source of capital.

Â So, for as far as a notation goes, Rd is going to be the required return on debt,

Â Re is going to be required return on equity, and sometimes you can

Â see people referring to these simply as the cost of debt and the cost of equity.

Â So, we're going to be using those terms interchangeably.

Â The required return on debt, on the cost of debt.

Â And the required return on equity, and

Â the cost of equity, all these things are going to be denoted by Rd and Re.

Â Them come the, then comes the corporate tax rate.

Â You know, the, the, the, the, we have to pay taxes on a personal level.

Â Corporations have to pay taxes.

Â And there's no getting away from that.

Â Some corporations pay more.

Â Some corporations pay less.

Â But at the end of the day, there is what we call a corporate tax rate.

Â This is what presumably, corporations would actually have to pay.

Â Of course, you know, some corporations may have to pay more,

Â because there are state taxes, and municipal taxes, and so forth.

Â Some corporations pay less, because they get all sorts of tax breaks and

Â all sorts of ways of reducing.

Â Not the taxes that they have to pay, but

Â the recent corporate tax rate that we're going to denote as TC.

Â A, and that TC you're seeing there is simply the notation for

Â the corporate tax rate.

Â And it's going to become important for the following reason.

Â And we're going to see an example.

Â A little bit later on.

Â It's going to become important because,

Â in just about every tax code in the world there's an asymmetry.

Â And the asymmetry means that, the following.

Â That when you pay interest on the debt, you do that before taxes.

Â But when you pay dividends, you do that after taxes.

Â What is the meaning of that?

Â Well, it means that when you pay your dollar of interest, that

Â actually reduces your profits and that means that you pay, you pay less taxes.

Â However, when you pay, a dollar of dividends, you do it after taxes.

Â Which means that it's an actual dollar.

Â So in the first case,

Â the dollar that you pay you're really effectively paying a little bit less.

Â Because you get a little bit of a tax break, which we're going to quantify.

Â A couple of minutes from now.

Â So basically when you pay $1 of interest and

Â $1 of dividends, the $1 of dividends is just a net dollar of dividends.

Â But that $1 of interest you need to account for

Â the fact that you get a tax break on that.

Â And so we can actually calculate, the after tax cost of debt.

Â And by after tax we mean taking into account that tax break, that tax shelter

Â that we get, when we have debt as opposed to equity in the capital structure.

Â So the notation that you see there, one minus tc multiplied by RD.

Â That's what we're going to call, the after tax cost of debt.

Â After taking into account that when we pay interest on the debt,

Â we get a tax break on that debt.

Â We're going to see a numerical example in a minute.

Â And this will become much more clear than it is now.

Â Again we're only defining notation at this point.

Â And that notation is TC, is going to be the corporate Tax rate,

Â and 1 minus TC multiplied by Rd is going to be the after-tax cost of them.

Â Finally the, the proportions,

Â again remember that's why we call it a weighted average cost of capital.

Â We need to take into account, how much we're using, in relative terms,

Â in this case, of debt and equity.

Â And, and we do that in a very simple way.

Â First we, we add up all the debt and all the equity that we have.

Â And that's what some people would call the capital invested,

Â the capital that we have to invest in long term projects.

Â And then we calculate, simply, the proportion D divided by the sum of D plus

Â E, as you see that we are going to call Xd, and E divided by the sum of D plus E,

Â as you see there also, that's what we're going to call Xe.

Â So, XD and xE are the proportions of debt and equity.

Â That a company's using to finance their investment activities.

Â Now there's one important thing here.

Â The, and this is just a side comment because again this is not one of

Â the issues that we're going to explore.

Â But the issue of capital structure is all about

Â determining the optimal proportions of xD and xE.

Â In other words you want to find.

Â