Weighted Average Cost of
Capital
WACC
Chapter - 12
Topic …. WACC
▪ Today’s Objective --- Learn how to calculate the “Weighted Average
Cost of Capital” better known as WACC
What is WACC?
▪ The opportunity cost of “Capital” for taking on risk in an investment
▪ In it’s most simple form…
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Equity makes up $50 of the total capital stock (50%)
Debt makes up $50 of the total capital stock (50%)
Equity Investors require a 20% return on their investment
Debt investors require a 10% return on their investment
On average the company must payout (20+10)/2, or 15%
If the company earns $1000 over the period, e.g., one year
▪ Debt Investors would get 10% x $1000 = $100
▪ Equity Investors would get 20% x $1000 = $200
▪ Or $1000 x 15% = $150 = ($100 +$200)/2 = $150
So… Where to do we use WACC?
Gather Financial Facts for your
Project
(Business Case Information)
Complete your Proforma Income and Cash
Flow Analysis
NPV = FCFF1 / (1+R)1 + FCFF2 / (1+R)2….. FCFFn / (1+R)n - (Initial costs)
Decision ---- IRR > R and NPV > 0
WACC = R
NPV = FCFF1 / (1+WACC)1 + FCFF2 / (1+WACC) 2… FCFFn / (1+WACC)n - (Initial costs)
Simple Steps for Calculating WACC
▪
Find the values for Debt, Equity and tax rate for your company
- Internal: Financial Statements (balance sheet)
- External: Publicly available data: 10k or secondary provider – S&P, Morningstar, etc. ( We will use
Morningstar)
▪
Calculate the company’s “Market” Cost of Debt (Rd) , i.e., what debt providers require as a return
for loaning the company money.
- Find the YTM of the company’s bonds
▪
Calculate the required return of Equity (Re) using the CAPM Model
- Re = Rf + Beta(Risk Premium)
▪
Plug the values into the WACC equation
Generalized Formula for WACC
▪ WACC = E/V x Re + D/V x Rd(1-Tc)
Where:
E= Amount of Equity of the company
D= Amount of Debt of the company
V = Total of Debt and Equity
Re = The percentage cost of equity
Rd = The percentage cost of debt
Tc = Tax rate
If you have preferred
Rp = Cost of preferred stock = (Preferred Dividend) / (Current Price of Stock)
Capital Structure Weights
E+D=V
E = Equity
D = Debt
V = Total Capital
e.g.,
E=5
D=5
V= 5 + 5
V = 10
E/V = 50%
D/V = 50%
How do we derive the individual components of WACC…..
“Capital Structure” Weights
▪ Use a trusted set of recent audited Financial Statements
E + D = V = Total Capital
▪ E + D = Total Capital
▪ Debt Capital
▪ Short Term Debt + Long Term Debt
E = Market Value of Equity
D = Market Value of Debt
▪ Equity Capital
▪ Price of the company’s stock x Number of shares outstanding
Determining the Company’s Cost of Debt
▪ Rd = Cost of the company’s “Debt”.
- Obtained from the YTM on the company’s outstanding bonds.
- Remember YTM ……
- Example: (10 year bond) (-$975 price) ($70 coupon) ($1000 Par value)
10
-$975
N
Solve for
I/Y
PV
(Price)
$70
PMT
(Coupon)
$1,000
FV
(Par Value)
7.36%
Morningstar and others (S&P, etc.) will have YTM on any publicly traded company
Cost of Equity
▪ Two ways to calculate “Cost of Equity”
▪ Dividend Growth Model & Capital Asset Pricing Model (CAPM)
▪ Dividend Growth Model
▪ P0 = D1 / (Re – g) which we can rearrange as
▪ Re = D1/P0 + g
▪ And…. D1 = (D0 + g)
▪ Problems with “Dividend Growth Model”…
▪ What if the company pays no dividends????
▪ Will g always be constant….????
▪ What about RISK ?
CAPM…… Cost of Equity
▪ Use the following information to compute the cost of equity
RE  R f   e ( E ( Rm )  R f )
Re = Rf = Beta (Risk Premium)
▪ Risk-free rate, Rf (Treasuries….)
▪ Market risk premium,
E(Rm) – Rf
▪ Systematic risk of asset,  , with the overall market, e.g., S&P 500 (Rm)
▪ e = Beta
β e  Corr Re, R m  
σe
σm
sigma….
▪ Standard & Poor's, Morningstar and Value Line provide betas for most domestic companies.
▪ CAPM 
RE  R f   e ( E ( Rm )  R f )
Example Best Buy’s WACC (BBY)
Your Turn
▪ Find a company from the S&P 500 and calculate the Beta for the stock.
▪ Online Guide -- Look at the WACC and Capital Structure Lecture:
▪ http://home.barton.edu/odrive/rlee/FIN301/pure-layout-sidemenu/Lectures.html