- The weighted-average cost of capital (WACC) is used to calculate the required rate of return for a firm's projects and value the entire firm. It is a weighted average of the costs of the firm's various sources of financing.
- To calculate the WACC, you first calculate the market values of the firm's debt and equity securities. You then determine the required rates of return for each security. Finally, you take a weighted average of the after-tax costs.
- The WACC represents the minimum return the firm must earn overall on new projects that have average risk. It provides the basis for net present value analysis and valuation of the entire firm.
The cost of funds used for financing a business. Cost of capital depends on the mode of financing used – it refers to the cost of equity if the business is financed solely through equity, or to the cost of debt if it is financed solely through debt. Many companies use a combination of debt and equity to finance their businesses, and for such companies, their overall cost of capital is derived from a weighted average of all capital sources, widely known as the weighted average cost of capital (WACC). Since the cost of capital represents a hurdle rate that a company must overcome before it can generate value, it is extensively used in the capital budgeting process to determine whether the company should proceed with a project.
,
cost of capital
,
bond
,
preferred stock
,
factors influencing cost of capital determination
,
cost of new common stock
,
cost of debt components
,
cost of preferred stock
,
components of cost of capital
2. 13
-2
The WACC and Company
Valuation
The required rate of return on a firm’s projects
can be calculated using the weighted-average
cost of capital.
The weighted-average cost of capital (WACC)
is the after-tax return the company needs to earn
in order to satisfy all its security holders.
3. 13
-3
Company Cost of Capital
Company Cost of Capital
• The opportunity cost of capital for the firm’s existing
assets. The minimum acceptable rate of return when
the firm expands by investing in average-risk projects.
Capital Structure
• The mix of long-term debt and equity financing.
Used to value new assets that have the same risk
as the old ones.
4. 13
-4
Company Cost of Capital
The company cost of capital is a weighted average
of returns demanded by debt and equity investors.
r D r E r
= é ´ ù + é ´ ù êë úû êë úû
assets debt equity
V V
5. 13
-5
Company Cost of Capital:
Example
Macrosoft, Inc. has issued long-term bonds with a present value
of $25 million and a yield of 8%. It currently has 12 million
shares outstanding, trading at $20 each, offering an expected
return of 14%. What is the firm’s cost of capital?
E =12,000,000´$20 = $240million
6. Weighted Average Cost of Capital
13
-6
For proper valuation we must value the firm’s
after-tax cash flows.
Why is it important to account for taxes?
7. Weighted Average Cost of Capital
The WACC provides a firm’s after-tax cost of
13
-7
capital.
WACC = D (1-T ) r + E r
é ´ ´ ù é ù êë V c debt úû êë ´ V
equity
úû
Where:
Tc = The firm’s average tax rate
8. 13
-8
Calculating WACC
A firm’s WACC is calculated in 3 steps:
1. Calculate the value of each security as a proportion
of firm value.
2. Determine the required rate of return on each
security.
3. Calculate a weighted average of the after-tax return
on the debt and return on the equity.
9. 13
-9
Calculating WACC: Example
What is the WACC for a firm with $30 million in outstanding debt with a
required return of 8%, 8 million in equity shares outstanding trading at $15
each with a required return of 12%, and a tax rate of 35%?
1.
2.
3.
10. ù
13
-
10
Calculating WACC
If there are 3 (or more) sources of financing, simply
calculate the weighted-average after-tax return of each
security type.
If the firm issues preferred stock:
úû
r + P
(1-T )r + E
WACC = D
êëé ´ c debt equity Preferred r
é ´ úû
êë
ù
é ´ úû
êë
ù
V
V
V
11. 13
-
11
Calculating WACC: Example
Consider a firm with $8 million in outstanding bonds, $15 million
worth of outstanding common stock, and $5 million worth of
outstanding preferred stock. Assume required returns of 8%, 12%, and
10%, respectively, and a 35% tax rate.
1.
2.
3.
12. 13
-
12
WACC and NPV
In our previous example, we calculated the
firm’s WACC to be 9.7%
Would NPV be positive or negative if:
• We invested in a project offering a 9% return?
• We invested in a project offering a 10% return?
• We invested in a project offering a 9.7% return?
13. 13
-
13
Measuring Capital Structure
When estimating WACC, use market values, not
book values.
Market Value of Debt
• Present Value of all coupons and principal, discounted
at the current YTM.
Market Value of Equity
• Market price per share multiplied by the number of
shares outstanding.
14. 13
-
14
Measuring Capital Structure:
Example
If a firm’s bonds pay a 5% coupon and mature in 3 years, what is
their market value, assuming a 7% yield to maturity? Assume the
bond has a $1,000 par value.
15. Calculating Expected Returns
To calculate the WACC, we must first calculate the
rates of return that investors expect from each security.
• Expected returns on bonds
• Expected returns on common stock
• Expected returns on preferred stock
13
-
15
16. 13
-
16
Expected Return on Bonds
The risk of bankruptcy aside, the yield to
maturity represents an investor’s expected
return on a firm’s bonds.
17. 13
-
17
Expected Return on Common
Stock
Estimating requity using CAPM:
Example: A firm’s beta is 1.5, Treasury bills currently yield 4%,
and the long-run market risk premium is 8%. What is the firm’s cost
of equity?
18. 13
-
18
Expected Return on Common
Stock
Estimating requity using the DDM:
Example: A firm’s shares are trading for $45 per share. The firm
is expected to pay a $2 per share dividend at the end of the year.
What is its expected return on equity assuming a 9% constant
growth rate?
19. 13
-
19
Expected Return on Preferred
Stock
A preferred stock that pays a fixed annual
dividend is no more than a simple perpetuity.
20. 13
-
20
Expected Return on Preferred
Stock: Example
If a share of preferred stock sells for $40 and it pays
a dividend of $3 per share, what is the expected
return on that share of stock?
21. 13
-
21
WACC Pitfalls
The WACC is appropriate only for projects that have
the same risk as the firm’s existing business.
Upward/Downward Adjustments
Altering Capital Structure
• Two costs of debt finance: Explicit and Implicit
22. 13
-
22
Altering Capital Structure:
Example
What is the WACC for a firm with $100 million in debt
requiring a 6% return and $400 million in equity requiring a
10% return? Assume a tax rate of 35%.
What if the firm borrows an additional $150 million to retire
some of its shares, but investors now demand 9% on the debt
and 12% on equity?
23. 13
-
23
Valuing Entire Businesses
We can treat entire companies like giant projects
and value them using the WACC.
Free Cash Flow
Cash flow that is not required for investment in
fixed assets or working capital and is therefore
available to investors.
24. 13
-
24
Valuing Entire Businesses
H
FCF
FCF
PV FCF
firm H H
H
WACC
PV
WACC
2
WACC
WACC
(1 ) (1 )
...
(1 ) 1
(1 )2
1
+
+
+
+ +
+
+
+
=
Horizon Value = FCF in year (H 1)
WACC g
+
-
25. 13
-
25
Valuing Entire Businesses: Example
Use the following information to calculate the value of a
business that your firm is considering acquiring.
Firm’s WACC: 12.5%
Firm’s Cash Flows
•$1 million FCF, years 1-4
•$1.05 million FCF, year 5
•5% growth after 4 years
26. 13
-
26
Valuing Entire Businesses: Example
H
FCF
FCF
PV FCF
firm H H
H
WACC
PV
WACC
2
WACC
WACC
(1 ) (1 )
...
(1 ) 1
(1 )2
1
+
+
+
+ +
+
+
+
=
Editor's Notes
Chapter 13 Learning Objectives
Calculate a firm’s capital structure.
Estimate the required rates of return on the securities issued by the firm.
Calculate the weighted-average cost of capital.
Understand when the weighted-average cost of capital is -or isn’t- the appropriate discount rate for a new project.
Use the weighed-average cost of capital to value a business given forecasts of its future cash flows.
Chapter 13 Outline
Company Cost of Capital
Capital Structure
Weighted Average Cost of Capital
3 Steps for Calculation
Using WACC with Multiple Sources of Financing
WACC and NPV
Measuring Capital Structure
Use Market Values
Calculating Expected Returns
Expected Return on Bonds
Expected Return on Common Stock
CAPM
DDM
Expected Return on Preferred Stock
WACC Pitfalls
Adjust WACC According to Risk
Altering Capital Structure
Valuing Entire Businesses
Company Cost of Capital – The opportunity cost of capital for the firm’s existing assets. The minimum acceptable rate of return when the firm expands by investing in average-risk projects.
Capital Structure – The mix of long-term debt and equity financing.
The weighted average is the expected rate of return investors would demand on a portfolio of all the firm’s outstanding securities.
Note: When calculating a firm’s cost of capital, always use market values, not book values.
The importance of taxes:
Most companies are financed by both equity and debt.
The interest payments on debt are deducted from income before tax is calculated.
Therefore, the cost to the company is reduced by the amount of their tax savings.
Weighted Average Cost of Capital (WACC) – Expected rate of return on a portfolio of all the firm’s securities, adjusted for tax savings due to interest payments.
If a project has zero NPV when the expected cash flows are discounted at the WACC, then the project’s cash flows are just sufficient to give debtholders and shareholders the returns they require.
Calculating market values:
Market value of debt:
PV of all coupons and principal, discounted at the current YTM.
Market value of equity:
Market price per share multiplied by the number of shares outstanding.
Note: The constant-growth formula can only be used for firms that have a stable and predictable growth pattern.
Do not use this formula for firms with very high current rates of growth, or firms with unpredictable rates of growth.
Firms that use WACC as a companywide benchmark can adjust the rate upward for unusually risky projects and downward for unusually safe projects.
Firms should not arbitrarily alter their capital structure in order to manipulate WACC.
If the firm increases its borrowing to lower its WACC, the lenders will likely demand a higher rate of interest on the debt.
There are two costs of debt finance:
Explicit Cost – the interest rate that bondholders demand.
Implicit Cost – borrowing increases the required return on equity.
Firms cannot simply increase their debt holdings in order to decrease their WACC.
Eventually both debtholders and shareholders will demand higher rates of return, leading to a higher WACC.
Free Cash Flow – Cash flow that is not required for investment in fixed assets or working capital and is therefore available to investors.
The value of an entire business is equal to the discounted value of the free cash flows out to some horizon year plus the forecasted value of the business at the horizon, discounted back to the present.
Note: Work through this example using both a financial calculator and a spreadsheet
