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- 1. How to Calculate WACC By: Mohamed Zohair Moh.zohair@gmail.com March, 2015
- 2. Expected Return Free Risk Return Rf Market Return Rm High Risk 3% 7% Expected return> 7%
- 3. Definitions Return • Rf is the return expected from the absolutely risk-free investment • Rm is the return expected from the market variance • Covariance measure of the degree to which returns on two risky assets move in tandem • Variance how far each number in the set is from the mean
- 4. The weighted average cost of capital (WACC) • For any firm the capital structure consists of equity and debt • Weighted value of each portion is • Equity / Value E/V • Debt / Value D/V • The WACC formula is WACC = Ke (E/V) + Kd (D/V) (1-Tc) where Ke is cost of equity Kd is cost of debt Tc is Tax rate Equity Debt Value = E + D
- 5. Common Question Sample • ABC company is aiming to expand their business by establishing a new production plant XYZ. This project will cost the company £xx million. With given information; Calculate the weighted average cost of capital (WACC).
- 6. Given information Equity Debt New Company Equity Debt Existing Company Common Given Information • Rf • Rm • Covariance • Variance • Tax rate • Existing Company • Cost of equity (Ke) • Capital Structure • New Company • Cost of dept (Kd) • Capital Structure
- 7. Calculation Formulas For Existing Company - Step 1: Beta = Covariance / Variance - Step 2: Ke = Rf + Beta ( Rm - Rf) - Step 3: WACC = Ke (E/V) + Kd (D/V) (1-Tc) To avoid the effect of debt (leveraged), we need to calculate the value of Unleveraged Beta - Step 4: Beta (unleverage) = Beta (leverage) / 1 + (D/E) (1-Tc) Equity Debt Equity Debt Existing Company New Company For New Company -Step 5: calculate new company Beta using formula # 4 -Step 6: Ke = Rf + Beta ( Rm - Rf) - Step 7: WACC = Ke (E/V) + Kd (D/V) (1-Tc) 1 2 3 4 2 3
- 8. Sample # 1 Common Given Information • Rf = 7% • Rm = 16% • Covariance = 1.5% • Variance = 1% • Tax rate = 40 % Companies information • Company EAM (Existing) • Cost of equity (Ke) ?? • Capital Structure D/E = 1.2 • Company DA (New) • Cost of dept (Kd) = 10% • Capital Structure 60 % Equity & 40 % Debt
- 9. Sample Requirements For Existing Company - Step 1: Beta = Covariance / Variance - Step 2: Ke = Rf + Beta ( Rm - Rf) - Step 3: WACC = Ke (E/V) + Kd (D/V) (1-Tc) To avoid the effect of debt (leveraged), we need to calculate the value of Unleveraged Beta - Step 4: Beta (unleverage) = Beta (leverage) / 1 + (D/E) (1-Tc) Equity Debt Equity Debt EAM DA For New Company -Step 5: calculate new company Beta using formula # 4 -Step 6: Ke = Rf + Beta ( Rm - Rf) - Step 7: WACC = Ke (E/V) + Kd (D/V) (1-Tc) 1 2 3 4 2 3
- 10. Sample Solution (a) Calculate beta & Ke of EAM - Step 1: Beta = Covariance / Variance = 1.5 / 1 = 1.5 -Step 2: Ke = Rf + Beta ( Rm - Rf) = 0.07 + (1.5) (.09) = 0.07 + .135 = 0.205 = 20.5% Equity Debt D/E = 60 /40 = 1.5 Cost of dept (Kd) = 10% Equity Debt D/E = 1.2 EAM DA
- 11. Sample Solution (b) unleverage Beta of EAM Beta (unleverage) = Beta (leverage) / 1 + (D/E) (1-Tc) = 1.5 / [1 + (1.2) (.6) = 1.5 / [1 + .72] = 1.5 / 1.72 = 0.8721 Equity Debt D/E = 60 /40 = 1.5 Cost of dept (Kd) = 10% Equity Debt D/E = 1.2 EAM DA
- 12. Sample Solution (c) Leverage Beta & Ke of DA Step 1: Beta (unleverage) = Beta (leverage) / 1 + (D/E) (1-Tc) Hence, Beta (leverage, Da) = Beta (unleverage, EAM) x [1 + (D/E) (1-Tc)] = 0.8721 x [ 1 + (1.5) (.6) ] = 0.8721 x [ 1+ .9) = 0.8721 x 1.9 = 1.6569 Note that, the D/E here for DA -Step 2: Ke = Rf + Beta ( Rm - Rf) = 0.07 + (1.6569) (.09) = 0.07 + .1491 = 0.2191 = 21.91% Equity Debt D/E = 60 /40 = 1.5 Cost of dept (Kd) = 10% Equity Debt D/E = 1.2 EAM DA
- 13. Sample Solution (d) WACC of DA Step 1: WACC = Ke (E/V) + Kd (D/V) (1-Tc) = (0.2191) (.6) + (0.1) (.4) (.6) = .1314 + 0.024 = .1554 = 15.54% Equity Debt D/E = 60 /40 = 1.5 Cost of dept (Kd) = 10% Equity Debt D/E = 1.2 EAM DA
- 14. Summary 4 Formulas Beta = Covariance / Variance Ke = Rf + Beta ( Rm - Rf) WACC = Ke (E/V) + Kd (D/V) (1-Tc) Beta (unleverage) = Beta (leverage) / 1 + (D/E) (1-Tc) 5 Common Given Information • Rf • Rm • Covariance • Variance • Tax rate 3 of 4 Companies Given Information • Company (Existing) • Cost of equity (Ke) • Capital Structure • Company (New) • Cost of dept (Kd) • Capital Structure
- 15. Exam Tips (1) The cost of debt and D/E may be given as information inside the credit rating agency table as below, Based on the company rate, get the D/E and cost of debt directly from table. Say, the company rated as BBB, that means D/E = .75 and Kd = 9.5%
- 16. Exam Tips (2) The existing company has no debts That means, Beta (unleverage) = Beta (leverage), and WACC = Ke (3) XYZ company will issue a 5 year bond with an annual coupon of 12% of the nominal-value of the bond. Even thought they will issue bond for 5 years, the cost of debt still 12% (annually)