In the case where the firm has just one type of debt and equity outstanding, the financial security portfolio return is
E(Rp) = XB*E(RB) + XS*E(RS), or
E(RP) = (B/(B+S)*E(RB) + (S/(B+S)*E(RS). (1)
Because I’m tired of typing expectations operators, I’m switching notation to
E(RB) = rB and E(RS) = rS.
Adjusting Equation (1) above to acknowledge corporate taxes, tc, we will have
E(RP) = (B/(B+S)*rB*(1 - tc) + (S/(B+S)*rS.
We refer to this equation as the Weighted Average Cost of Capital Equation, or the WACC. The short story is that the WACC represents the overall required rate of return (discount rate) for projects if they have
the average business risk of the firm, and
financing in the same financing proportions as represented in the WACC calculations.
I’ll provide the intuition for this equation in class. Since we will come back to the development of this equation, and the logic for the corporate tax adjustment to debt, later in the class, I don’t want to spend too much time on this equation at this point.