Weighted Average Cost of
Capital
(WACC)
What is WACC?
WACC is the cost of capital for a business that
raises capital from more than one source
Public companies raise money by selling
– Debt
– Preferred stock
– Common Stock
WACC reflects the overall mix of securities in the
capital structure
Assets
Debt
Preferred Stock
Common Stock
Use of WACC
WACC is used as a discount rate for
evaluating investment projects
It is the ‘r’ for NPV calculations
WACC reflects the risk of the entire
company
WACC is only appropriate to use when the
project is of the same risk as the entire
company
WACC Formula
D
P
E
WACC  rD 1  T   rP  rE
V
V
V
It is important to understand the inputs to the
WACC formula
WACC Inputs 1
D = market value of all debt
P = market value of preferred stock
E = market value of common stock
V = D + P + E = Market value of the entire firm
D/V, P/V, and E/V are the capital structure
weights – the proportion of the firm financed by
debt, preferred and common stock
WACC Inputs 2
rD = cost of debt
rP = cost of preferred stock
rE = cost of common stock
T = marginal corporate tax rate
We will learn how to estimate all of these
Cost of Debt (rD)
Cost of debt is the YTM of the bonds that
a company issues
If there are more than one type of bonds,
then you must take the weighted average
of all the YTMs
Weights to be used here are based on
market values of bonds
Example rD
A company has the following bonds
outstanding. What is its overall rD?
Coupon
(%)
6.375
Book
Market
Value ($m) Value ($m)
499
521
YTM
(%)
5.5
7.250
495
543
6.5
7.625
200
226
6.6
Example rD
Total market value of bonds:
521 + 543 + 226 = $ _______
Weights of each bond issue:
521/____
543/____
= ____
=____
226/____
=____
Overall rD =___ x .055 + ___ x .065 + ___ x .066
= _______
Cost of Preferred (rP)
D
rP 
P0
Use perpetuity formula:
– D is the annual dividend on preferred stock
– P0 is the latest preferred stock price
Example rP
The company has 1 million shares of 8%
preferred stock selling for $120 today.
What is rP?
rP = _____ / _____ = ______
Note: 8% preferred means the company
pays a preferred dividend of 8% of its par
value which is always $100
Cost of Common Equity (rE)
rE can be estimated in one of two ways:
CAPM equation: rE = Rf + [E(Rm) – Rf] x β
OR
Constant growth formula: rE = D1/P0 + g
Example rE
The company has 80 million shares of
common stock outstanding. The per share
book value is $19.10 and the market price
is $62.50. T-bills yield 5%, the market risk
premium is 6%, and the stock’s beta is 1.1
What is the company’s cost of common
equity according to CAPM?
rE = _______
Example rE
The same company just paid a dividend of
$5 and analysts estimate that the
dividends will grow at 4% rate forever.
What is the company’s rE according to
constant growth model?
rE = ________
Note on rE
Most companies do not have dividends
growing at a constant rate forever
It is better to use CAPM equation to
estimate the cost of common equity
You must use one of the two methods to
estimate rE
Use caution when using constant growth
method
Capital Structure Weights
From previous information compute:
D/V = ____ / ____ = _____
P/V = ____ / ____ = _____
E/V = ____ / ____ = _____
Assume marginal corporate tax rate (T) of
40%
Putting it together…
From previous information, what is the
company’s WACC?
Answer: WACC = ___________
Things to remember
All the inputs to WACC formula must be based
on market values
Sometimes market value of bond is difficult to
obtain
– In this case you may use book value as an
approximation
Stock prices are easy to obtain – never use book
values!
Another Example
Independence Mining Corporation (IMC) has 7 million
shares of common stock outstanding, 1 million shares of
6 percent preferred outstanding, and 100,000 $1,000
par, 9 percent semiannual coupon bonds outstanding.
The stock sells for $35 per share and has a beta of 1.2,
the preferred stock sells for $60 per share, and the
bonds have 15 years to maturity and sell for 89 percent
of par. The market risk premium is 5.5 percent, T-bills are
yielding 6 percent, and the firm’s tax rate is 34 percent.
Compute IMC’s WACC
Example continued
If IMC is evaluating a mining expansion
project that is as risky as the firm’s typical
project, what rate should they use to
discount the project’s cash flows?
If IMC is thinking of going into shipping
business, can it use the current WACC to
discount the shipping project’s cash flows?
Caution on using WACC
If a firm is considering a project that is
substantially different in risk than the firms
current operations
it CANNOT use the WACC to evaluate this new
project
It must estimate WACC of other companies that
are in the same line of business as the new
project
The bottom line in finance
In any discounting of cash flows
ALWAYS USE A DISCOUNT RATE (r, in
the denominator) THAT REFLECTS THE
RISK OF THE CASH FLOWS (in the
numerator)
Recap
We started with TVM
We always compare cash flows
occuring at different times at the same
point in time
– compare apples with apples
Value of ANY asset is simply the PV of
ALL future cash flows
For TVM you need cash flows and ‘r’
Recap
Cash flows for different assets have
different names:
– For Stocks: cash flows are dividends
– For Bonds: cash flows are interest/principal
– For Projects: cash flows are project cash
flows
Cash flows often need to be estimated
Recap
‘r’ (in general, interest rate or discount
rate) has different names for different
assets:
– For Stocks: required rate of return
– For Bonds: yield
– For Projects: cost of capital
‘r’ always depends on the riskiness of
cash flows
– according to CAPM, risk is measured by
beta
What is finance?
Understanding risk and return is a major
part of finance
Most of what we do in finance always
comes back to understanding this
simple tradeoff