Weighted Average Cost of Weighted Average Cost of CapitalCapital

(WACC)(WACC)

What is WACC?What is WACC?

WACC is the WACC is the cost of capitalcost of capital for a business that for a business that raises capital from more than one sourceraises capital from more than one source

Public companies raise money by sellingPublic companies raise money by selling– DebtDebt– Preferred stockPreferred stock– Common StockCommon Stock

WACC reflects the WACC reflects the overall mixoverall mix of securities in the of securities in the capital structurecapital structure

Assets DebtPreferred StockCommon Stock

Use of WACCUse of WACC

WACC is used as a discount rate for WACC is used as a discount rate for evaluating investment projectsevaluating investment projects

It is the ‘r’ for NPV calculationsIt is the ‘r’ for NPV calculations

WACC reflects the risk of the entire WACC reflects the risk of the entire companycompany

WACC is only appropriate to use when the WACC is only appropriate to use when the project is of the same risk as the entire project is of the same risk as the entire companycompany

WACC FormulaWACC Formula

EPD rV

Er

V

PTr

V

DWACC 1

It is important to understand the inputs to the It is important to understand the inputs to the WACC formulaWACC formula

WACC Inputs 1WACC Inputs 1

D = market value of all debtD = market value of all debt

P = market value of preferred stockP = market value of preferred stock

E = market value of common stockE = market value of common stock

V = D + P + E = Market value of the entire firmV = D + P + E = Market value of the entire firm

D/V, P/V, and E/V are the capital structure D/V, P/V, and E/V are the capital structure weights – the proportion of the firm financed by weights – the proportion of the firm financed by debt, preferred and common stockdebt, preferred and common stock

WACC Inputs 2WACC Inputs 2

rrDD = cost of debt = cost of debt

rrPP = cost of preferred stock = cost of preferred stock

rrEE = cost of common stock = cost of common stock

T = marginal corporate tax rateT = marginal corporate tax rate

We will learn how to estimate all of theseWe will learn how to estimate all of these

Cost of Debt (rCost of Debt (rDD))

Cost of debt is the YTM of the bonds that Cost of debt is the YTM of the bonds that a company issuesa company issues

If there are more than one type of bonds, If there are more than one type of bonds, then you must take the weighted average then you must take the weighted average of all the YTMsof all the YTMs

Weights to be used here are based on Weights to be used here are based on market values of bondsmarket values of bonds

Example rExample rDD

A company has the following bonds A company has the following bonds outstanding. What is its overall routstanding. What is its overall rDD??

CouponCoupon

(%)(%)

Book Book Value ($m)Value ($m)

Market Market Value ($m)Value ($m)

YTMYTM

(%)(%)

6.3756.375 499499 521521 5.55.5

7.2507.250 495495 543543 6.56.5

7.6257.625 200200 226226 6.66.6

Example rExample rDD

Total market value of bonds:Total market value of bonds:521 + 543 + 226 = $ _______521 + 543 + 226 = $ _______

Weights of each bond issue:Weights of each bond issue:521/____521/____ 543/____543/____ 226/____226/____= ____= ____ =____=____ =____=____

Overall rOverall rDD =___ x .055 + ___ x .065 + ___ x .066 =___ x .055 + ___ x .065 + ___ x .066

= _______ = _______

Cost of Preferred (rCost of Preferred (rPP))

0P

DrP

Use perpetuity formula:Use perpetuity formula:

– D is the annual dividend on preferred stockD is the annual dividend on preferred stock

– PP00 is the latest preferred stock price is the latest preferred stock price

Example rExample rPP

The company has 1 million shares of 8% The company has 1 million shares of 8% preferred stock selling for $120 today. preferred stock selling for $120 today. What is rWhat is rPP??

rrPP = _____ / _____ = ______ = _____ / _____ = ______

Note: 8% preferred means the company Note: 8% preferred means the company pays a preferred dividend of 8% of its par pays a preferred dividend of 8% of its par value which is always $100value which is always $100

Cost of Common Equity (rCost of Common Equity (rEE))

rrEE can be estimated in one of two ways: can be estimated in one of two ways:

CAPM equation: rCAPM equation: rEE = R = Rff + [E(R + [E(Rmm) – R) – Rff] x ] x ββ

OROR

Constant growth formula: rConstant growth formula: rEE = D = D11/P/P00 + g + g

Example rExample rEE

The company has 80 million shares of The company has 80 million shares of common stock outstanding. The per share common stock outstanding. The per share book value is $19.10 and the market price book value is $19.10 and the market price is $62.50. T-bills yield 5%, the market risk is $62.50. T-bills yield 5%, the market risk premium is 6%, and the stock’s beta is 1.1premium is 6%, and the stock’s beta is 1.1

What is the company’s cost of common What is the company’s cost of common equity according to CAPM?equity according to CAPM?

rrEE = _______ = _______

Example rExample rEE

The same company just paid a dividend of The same company just paid a dividend of $5 and analysts estimate that the $5 and analysts estimate that the dividends will grow at 4% rate forever.dividends will grow at 4% rate forever.

What is the company’s rWhat is the company’s rEE according to according to

constant growth model?constant growth model?

rrEE = ________ = ________

Note on rNote on rEE

Most companies do not have dividends Most companies do not have dividends growing at a constant rate forevergrowing at a constant rate forever

It is better to use CAPM equation to It is better to use CAPM equation to estimate the cost of common equityestimate the cost of common equity

You must use You must use oneone of the two methods to of the two methods to estimate restimate rEE

Use caution when using constant growth Use caution when using constant growth methodmethod

Capital Structure WeightsCapital Structure Weights

From previous information compute:From previous information compute:

D/V = ____ / ____ = _____D/V = ____ / ____ = _____P/V = ____ / ____ = _____P/V = ____ / ____ = _____E/V = ____ / ____ = _____E/V = ____ / ____ = _____

Assume marginal corporate tax rate (T) of Assume marginal corporate tax rate (T) of 40%40%

Putting it together…Putting it together…

From previous information, what is the From previous information, what is the company’s WACC?company’s WACC?

Answer: WACC = ___________Answer: WACC = ___________

Things to rememberThings to remember

All the inputs to WACC formula must be based All the inputs to WACC formula must be based on market valueson market values

Sometimes market value of bond is difficult to Sometimes market value of bond is difficult to obtainobtain– In this case you may use book value as an In this case you may use book value as an

approximationapproximation

Stock prices are easy to obtain – never use book Stock prices are easy to obtain – never use book values!values!

Another ExampleAnother Example

Independence Mining Corporation (IMC) has 7 million Independence Mining Corporation (IMC) has 7 million shares of common stock outstanding, 1 million shares of shares of common stock outstanding, 1 million shares of 6 percent preferred outstanding, and 100,000 $1,000 6 percent preferred outstanding, and 100,000 $1,000 par, 9 percent semiannual coupon bonds outstanding. par, 9 percent semiannual coupon bonds outstanding. The stock sells for $35 per share and has a beta of 1.2, The stock sells for $35 per share and has a beta of 1.2, the preferred stock sells for $60 per share, and the the preferred stock sells for $60 per share, and the bonds have 15 years to maturity and sell for 89 percent bonds have 15 years to maturity and sell for 89 percent of par. The market risk premium is 5.5 percent, T-bills of par. The market risk premium is 5.5 percent, T-bills are yielding 6 percent, and the firm’s tax rate is 34 are yielding 6 percent, and the firm’s tax rate is 34 percent.percent.

Compute IMC’s WACCCompute IMC’s WACC

Example continuedExample continued

If IMC is evaluating a mining expansion If IMC is evaluating a mining expansion project that is as risky as the firm’s typical project that is as risky as the firm’s typical project, what rate should they use to project, what rate should they use to discount the project’s cash flows?discount the project’s cash flows?

If IMC is thinking of going into shipping If IMC is thinking of going into shipping business, can it use the current WACC to business, can it use the current WACC to discount the shipping project’s cash flows?discount the shipping project’s cash flows?

Caution on using WACCCaution on using WACC

If a firm is considering a project that is If a firm is considering a project that is substantially different in risk than the firms substantially different in risk than the firms current operationscurrent operations

it CANNOT use the WACC to evaluate this new it CANNOT use the WACC to evaluate this new projectproject

It must estimate WACC of other companies that It must estimate WACC of other companies that are in the same line of business as the new are in the same line of business as the new projectproject

The bottom line in financeThe bottom line in finance

In In anyany discounting of cash flows discounting of cash flows

ALWAYS USE A DISCOUNT RATE (r, in ALWAYS USE A DISCOUNT RATE (r, in the denominator) THAT REFLECTS THE the denominator) THAT REFLECTS THE RISKRISK OF THE CASH FLOWS (in the OF THE CASH FLOWS (in the numerator)numerator)

RecapRecap

We started with TVMWe started with TVM

We always compare cash flows occuring at We always compare cash flows occuring at different times at the same point in timedifferent times at the same point in time– compare apples with applescompare apples with apples

Value of ANY asset is simply the PV of ALL Value of ANY asset is simply the PV of ALL future cash flowsfuture cash flows

For TVM you need cash flows and ‘r’For TVM you need cash flows and ‘r’

Recap Recap

Cash flows for different assets have Cash flows for different assets have different names:different names:– For StocksFor Stocks: cash flows are dividends: cash flows are dividends– For BondsFor Bonds: cash flows are interest/principal: cash flows are interest/principal– For ProjectsFor Projects: cash flows are project cash : cash flows are project cash

flowsflows

Cash flows often need to be Cash flows often need to be estimatedestimated

RecapRecap‘‘r’ (in general, interest rate or discount rate) r’ (in general, interest rate or discount rate) has different names for different assets:has different names for different assets:– For StocksFor Stocks: required rate of return: required rate of return– For BondsFor Bonds: yield: yield– For ProjectsFor Projects: cost of capital: cost of capital

‘‘r’ r’ alwaysalways depends on the riskiness of cash depends on the riskiness of cash flowsflows– according to CAPM, risk is measured by betaaccording to CAPM, risk is measured by beta– more the risk the higher is ‘r’more the risk the higher is ‘r’

What is finance?What is finance?

Understanding Understanding risk and returnrisk and return is a major is a major part of financepart of finance

Most of what we do in finance always Most of what we do in finance always comes back to understanding this simple comes back to understanding this simple tradeofftradeoff