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The Weighted Average Cost of Capital

What Does "Cost of Capital" Mean? "Cost of capital" is defined as "the opportunity cost of all capital invested in an enterprise." Let's dissect this definition: Opportunity cost is what you give up as a consequence of your decision to use a scarce resource in a particular way. All capital invested is the total amount of cash invested into a business. In an enterprise this refers to the fact that we are measuring the opportunity cost of all sources of capital which include debt and equity. How Do We Calculate a Company's Weighted Average Cost of Capital? We calculate a company's weighted average cost of capital using a 3 step process: 1. Cost of capital components. First, we calculate or infer the cost of each kind of capital that the enterprise uses, namely debt and equity. A. Debt capital. The cost of debt capital is equivalent to actual or imputed interest rate on the company's debt, adjusted for the tax-deductibility of interest expenses. Specifically: The after-tax cost of debt-capital = The Yield-to-Maturity on long-term debt x (1 minus the marginal tax rate in %) We enter the marginal corporate tax rate in the worksheet "WACC." B. Equity capital. Equity shareholders, unlike debt holders, do not demand an explicit return on their capital. However, equity shareholders do face an implicit opportunity cost for investing in a specific company, because they could invest in an alternative company with a similar risk profile. Thus, we infer the opportunity cost of equity capital. We can do this by using the "Capital Asset Pricing Model" (CAPM). This model says that equity shareholders demand a minimum rate of return equal to the return from a risk-free investment plus a return for bearing extra risk. This extra risk is often called the "equity risk premium", and is equivalent to the risk premium of the market as a whole times a multiplier--called "beta"--that measures how risky a specific security is relative to the total market. Thus, the cost of equity capital = Risk-Free Rate + (Beta times Market Risk Premium). 2. Capital structure. Next, we calculate the proportion that debt and equity capital contribute to the entire enterprise, using the market values of total debt and equity to reflect the investments on which those investors expect to earn a minimum return.

3. Weighting the components. Finally, we weight the cost of each kind of capital by the proportion that each contributes to the entire capital structure. This gives us the Weighted Average Cost of Capital (WACC), the average cost of each dollar of cash employed in the business.

Case Study: Gateway Construction Pty Ltd. (India)

To demonstrate how to calculate a company's cost of capital, we will use the Gateway case study. 1. Cost of capital components. Gateway draws upon two major sources of capital from the capital markets: debt and equity. A. Cost of debt capital. Gateway had debt of $8.5 million. Enter this figure in the appropriate cell of worksheet "WACC."

Our first step in calculating any company's cost of capital is to consult the relevant annual report. This document tells us that Gateway has two components to its total debt of $8.5 million: Regular debt. Capital leases. Gateway also has "capital leases." A capital lease is a debt-like agreement in which a firm agrees to pay fixed amounts to someone who leases them land or equipment. \ Because there are two kinds of debt with different interest rates, we have to weight the different interest rates associated with each kind of debt by the relevant proportion of debt that each comprises. In this case, the weighted pre-tax cost of debt would be equivalent to 11.5%. Enter the pre-tax cost of debt in cell C5 of worksheet "WACC." However, we are not done yet. We noted above that we have to adjust for the tax-deductibility of interest expenses, which lowers the cost of debt according to the following formula: After-Tax Cost of Debt Capital = The Yield-to-Maturity on long-term debt x (1 minus the marginal tax rate) Given Gateway's marginal tax rate of 30%, the company's after-tax cost of debt equates to 11.5% x (100% minus 30%), or 8.1%. We see this calculation in the worksheet "WACC." Please note that in this example, we have used a company's actual cost of debt as a proxy for its marginal cost of long-term debt. A company's marginal cost of long-term debt may be better estimated by summing the risk-free rate and the "credit spread" that lenders would charge a company with a specific credit rating. B. Cost of equity capital. We noted above that: Cost of Equity Capital = Risk-Free Rate + (Beta times Market Risk Premium). To calculate any company's cost of equity capital, we need to find a reliable source for each of these inputs: 1. Risk-free Rate. We suggest using the rate of return on long-term (ten-year) US government treasury bonds as a proxy for the risk-free rate. (Or German Bunds for Euros). We enter this data point in cell C4 of worksheet "WACC." Sources for this include: - the Financial Times web site

2. Beta coefficient. We enter this data point in cell C8 of worksheet "WACC." In this case we have selected the industry beta for "Building - Heavy Construction" from the the worksheet "Industry Betas, obtained from Enter 1.66 for Gateway's beta. There are a variety of sources available for obtaining the beta coefficient for a particular company. Yahoo. Yahoo offers free beta estimates through its Company Profile service. Click here to see Gateway's Company Profile on Yahoo. Bloomberg. Free beta estimates from Bloomberg can be accessed online. Bloomberg's estimate of Gateway's current beta can be accessed here. for industry betas - helpful for private companies and emerging markets 3. Equity Risk Premium. Forward looking approaches, as well as more recent historical data, suggest an equity risk premium in the 3 to 5 percent range. Additional factors can raise this, as noted below. We use an Equity Risk Premium estimate of 7.5% for this family-dominated Indian company. We enter this data point in cell C7 of worksheet "WACC." In addition to the calculated risk premium, additional required return may be needed for: - Private equity illiquidity risk - Minority shareholding/corporate governance risk premium - Country risk For those interested in looking at historical equity risk premia, we refer you to the following online resources: Ibbotson Associates. Ibbotson sells a report on historical risk premia over time on its website. The report can be purchased. Aswath Damodaran. Valuation expert Professor Damodaran of NYU's Stern School of Business has published data as well as an informative article on equity risk premia that can be downloaded free of charge.

To continue with our Gateway case study, we used the following estimates for these three factors: Risk-free rate of 4%. Beta coefficient of 1.66. Equity risk premium of 7.5%. Using these estimates, Gateway's cost of equity capital = Risk-Free Rate + (Beta times Market Risk Premium).= 4.00% + (1.66 x 7.5%), or 16.5%. We see this calculation in the results section of worksheet "WACC."

3. Weighting the components. Finally, we weight the cost of each kind of capital by the proportion that each kind of capital contributes to the entire enterprise. This gives us the Weighted Average Cost of Capital (WACC), the average cost of each dollar of cash employed in the business.

To review, Gateway's after-tax cost of debt is 8.1% and its cost of equity is 16.5%. The market value of Gateway's debt is equal to $8.5 million and the market value of Gateway's equity is $45 million. The value of equity can be obtained from the shares outstanding and share price in cells C12 and C13 in worksheet "WACC." Alternatively, for private companies, the value of the business may be computed using comparables or a valuation model. Gateway's weighted average cost of capital is thus 8.1% x 15.9% + 16.5% x 84.1% = 15.1%. You can see this calculation in worksheet "WACC." By Ian Giddy Available as spreadsheet WACC_tutorial.xls on Acknowledgement: Adapted from

Inputs for WACC Calculation:

Risk free rate (%) Yield-to-Maturity of debt (%) Equity risk premium (%) Beta of equity Corporate tax rate (%) Common shares (MM) Share price ($) Market value of debt ($, MM) 4.00% 11.50% 7.50% 1.66 30% 10.0 4.50 8.5

$ $

Industry Betas (these data can be updated from Industry Advanced Materials/Prd Advertising Agencies Advertising Sales Advertising Services Aerospace/Defense Aerospace/Defense-Equip Agricultural Biotech Agricultural Chemicals Agricultural Operations Air Pollution Control Eq Airlines Airport Develop/Maint Apparel Manufacturers Appliances Applications Software Athletic Equipment Athletic Footwear Audio/Video Products Auto Repair Centers Auto-Cars/Light Trucks Auto-Med&Heavy Duty Trks Auto/Trk Prts&Equip-Orig Auto/Trk Prts&Equip-Repl B2B/E-Commerce Batteries/Battery Sys Beverages-Non-alcoholic Beverages-Wine/Spirits Bicycle Manufacturing Bldg Prod-Air&Heating Bldg Prod-Cement/Aggreg Bldg Prod-Doors&Windows Bldg Prod-Wood Bldg-Mobil Home/Mfd Hous Bldg-Residential/Commer Bldg&Construct Prod-Misc Blood Collection Banking Brewery Broadcast Serv/Program Building-Heavy Construct Building-Maint&Service Building&Construct-Misc Cable TV Capacitors Casino Hotels Casino Services Cellular Telecom Ceramic Products Chemicals-Diversified Chemicals-Fibers Beta 1.51 1.09 0.25 1.64 0.97 1.44 1.11 1.28 1.40 1.04 1.34 0.99 1.11 1.29 1.07 1.06 1.01 1.14 1.87 1.33 1.31 1.13 1.01 0.76 1.02 0.88 1.13 1.71 1.18 1.32 1.86 1.49 1.40 1.70 1.19 NA 0.88 1.23 1.66 1.80 1.65 0.68 1.52 1.11 1.53 1.16 1.15 1.23 1.56

Chemicals-Other Chemicals-Plastics Chemicals-Specialty Circuit Boards Circuits Closed-end Funds Coal Coatings/Paint Coffee Collectibles Commer Banks Non-US Commercial Serv-Finance Commercial Services Communications Software Computer Aided Design Computer Data Security Computer Graphics Computer Services Computer Software Computers Computers-Integrated Sys Computers-Memory Devices Computers-Other Computers-Peripher Equip Consulting Services Consumer Products-Misc Containers-Metal/Glass Containers-Paper/Plastic Cooperative Banks Cosmetics&Toiletries Cruise Lines Crystal&Giftware Data Processing/Mgmt Decision Support Softwar Dental Supplies&Equip Derivatives Diagnostic Equipment Diagnostic Kits Diamonds/Precious Stones Direct Marketing Disposable Medical Prod Distribution/Wholesale Divers Oper/Commer Serv Diversified Finan Serv Diversified Manufact Op Diversified Minerals Diversified Operations Drug Delivery Systems E-Commerce/Products E-Commerce/Services E-Services/Consulting Educational Software

1.48 1.31 1.23 1.34 1.60 0.33 1.34 0.97 0.82 0.70 1.33 0.97 0.98 0.85 2.05 1.45 1.38 1.02 1.36 1.53 1.20 1.51 1.03 1.36 1.28 1.54 1.09 1.05 1.03 1.00 0.67 0.53 1.27 0.90 0.41 NA 1.05 2.07 1.21 NA 1.00 1.26 1.44 1.39 1.48 1.55 1.49 0.77 1.30 1.18 1.36 1.21

Electric Products-Misc Electric-Distribution Electric-Generation Electric-Integrated Electric-Transmission Electronic Compo-Misc Electronic Compo-Semicon Electronic Connectors Electronic Design Automa Electronic Measur Instr Electronic Parts Distrib Electronic Secur Devices Electronics-Military Energy-Alternate Sources Engineering/R&D Services Engines-Internal Combust Enterprise Software/Serv Entertainment Software Environ Consulting&Eng Explosives Extended Serv Contracts Feminine Health Care Prd Filtration/Separat Prod Finance-Auto Loans Finance-Commercial Finance-Consumer Loans Finance-Credit Card Finance-Invest Bnkr/Brkr Finance-Investment Fund Finance-Leasing Compan Finance-Mtge Loan/Banker Finance-Other Services Firearms&Ammunition Fisheries Food-Baking Food-Canned Food-Catering Food-Confectionery Food-Dairy Products Food-Flour&Grain Food-Meat Products Food-Misc/Diversified Food-Retail Food-Wholesale/Distrib Footwear&Related Apparel Forestry Funeral Serv&Rel Items Gambling (Non-Hotel) Gas-Distribution Gas-Transportation Gold Mining Golf

1.15 1.28 1.34 1.17 1.38 1.33 1.55 1.51 1.55 1.19 1.47 1.41 1.32 1.44 1.64 1.41 1.32 1.68 1.14 1.37 0.94 0.30 0.74 0.91 1.17 0.97 0.48 1.97 0.48 1.24 1.18 1.39 2.11 1.29 1.03 0.94 0.96 1.12 1.02 1.42 1.15 1.21 1.04 1.17 0.91 1.39 1.13 1.75 1.03 NA 1.52 0.93

Hazardous Waste Disposal Health Care Cost Contain Healthcare Safety Device Home Decoration Products Home Furnishings Hospital Beds/Equipment Hotels&Motels Housewares Human Resources Identification Sys/Dev Import/Export Inactive/Unknown Independ Power Producer Industr Audio&Video Prod Industrial Automat/Robot Industrial Gases Instruments-Controls Instruments-Scientific Insurance Brokers Interior Design/Architec Internet Applic Sftwr Internet Brokers Internet Connectiv Svcs Internet Content-Entmnt Internet Content-Info/Ne Internet Gambling Internet Incubators Internet Infrastr Equip Internet Infrastr Sftwr Internet Security Internet Telephony Intimate Apparel Invest Comp - Resources Invest Mgmnt/Advis Serv Investment Companies Lasers-Syst/Components Leisure&Rec Products Leisure&Rec/Games Life/Health Insurance Lighting Products&Sys Linen Supply&Rel Items Lottery Services Mach Tools&Rel Products Machinery-Constr&Mining Machinery-Electric Util Machinery-Electrical Machinery-Farm Machinery-General Indust Machinery-Material Handl Machinery-Print Trade Machinery-Pumps Machinery-Therml Process

1.51 3.96 1.10 1.16 0.87 0.72 1.15 0.84 1.53 1.48 1.60 1.34 1.18 1.09 1.23 1.36 1.28 1.39 0.95 1.05 1.42 1.35 1.09 1.67 0.79 1.05 3.56 1.28 0.70 1.27 1.60 0.87 1.87 1.18 1.41 1.52 1.27 3.29 1.19 1.69 NA 1.67 1.41 1.36 1.39 1.16 1.61 1.37 1.60 1.42 1.13 1.55

Marine Services Medical Imaging Systems Medical Information Sys Medical Instruments Medical Labs&Testing Srv Medical Laser Systems Medical Products Medical Steriliz Product Medical-Biomedical/Gene Medical-Drugs Medical-Generic Drugs Medical-HMO Medical-Hospitals Medical-Outptnt/Home Med Medical-Whsle Drug Dist Metal Processors&Fabrica Metal Products-Distrib Metal Products-Fasteners Metal-Aluminum Metal-Copper Metal-Diversified Metal-Iron Mining Services Miscellaneous Manufactur Money Center Banks Mortgage Banks Motion Pictures&Services Motorcycle/Motor Scooter Multi-line Insurance Multilevel Dir Selling Multimedia Music Networking Products Non-Ferrous Metals Non-hazardous Waste Disp Not classified Office Automation&Equip Office Furnishings-Orig Office Supplies&Forms Oil Comp-Explor&Prodtn Oil Comp-Integrated Oil Field Mach&Equip Oil Refining&Marketing Oil-Field Services Oil&Gas Drilling Optical Supplies Paper&Related Products Pastoral&Agricultural Patient Monitoring Equip Petrochemicals Pharmacy Services Photo Equipment&Supplies

1.65 1.31 1.00 1.59 1.04 NA 1.41 1.32 1.10 1.13 1.11 NA 0.87 0.93 1.18 1.53 1.50 1.07 1.50 1.18 1.53 1.25 1.21 1.21 0.72 1.57 1.27 1.23 1.17 0.68 1.16 1.04 1.60 1.90 1.39 0.91 1.56 0.92 1.73 1.59 1.46 2.18 1.31 1.71 1.68 0.73 1.16 1.20 1.39 1.33 NA 1.56

Phys Practice Mgmnt Pipelines Platinum Pollution Control Poultry Power Conv/Supply Equip Precious Metals Printing-Commercial Professional Sports Property Trust Property/Casualty Ins Protection-Safety Public Thoroughfares Publishing-Books Publishing-Newspapers Publishing-Periodicals Quarrying Racetracks Radio Real Estate Mgmnt/Servic Real Estate Oper/Develop Recreational Centers Recycling Regional Banks-Non US Reinsurance Remediation Services Rental Auto/Equipment Research&Development Resorts/Theme Parks Respiratory Products Retail-Apparel/Shoe Retail-Appliances Retail-Auto Parts Retail-Automobile Retail-Bookstore Retail-Building Products Retail-Catalog Shopping Retail-Computer Equip Retail-Consumer Electron Retail-Convenience Store Retail-Discount Retail-Drug Store Retail-Hair Salons Retail-Home Furnishings Retail-Hypermarkets Retail-Jewelry Retail-Major Dept Store Retail-Misc/Diversified Retail-Office Supplies Retail-Perfume&Cosmetics Retail-Petroleum Prod Retail-Regnl Dept Store

1.30 1.42 1.75 1.18 1.06 1.47 1.52 1.16 0.46 0.45 1.29 0.78 1.28 0.76 1.05 0.91 1.02 0.38 0.76 1.30 1.56 1.00 1.32 1.15 0.96 0.78 1.29 2.55 1.09 0.63 1.20 1.15 0.36 1.17 NA 1.09 2.28 1.26 1.06 0.93 0.81 1.28 0.87 1.16 0.81 1.17 1.43 1.29 1.04 1.03 1.15 1.21

Retail-Restaurants Retail-Sporting Goods Retail-Toy Store Rubber-Tires Rubber/Plastic Products Rubber&Vinyl Satellite Telecom Schools Security Services Seismic Data Collection Semicon Compo-Intg Circu Semiconductor Equipment Shipbuilding Silver Mining Soap&Cleaning Prepar Special Purpose Banks Special Purpose Entity Specified Purpose Acquis Steel Pipe&Tube Steel-Producers Steel-Specialty Stevedoring Storage/Warehousing Sugar Superconductor Prod&Sys Tannery Tea Telecom Eq Fiber Optics Telecom Services Telecommunication Equip Telephone-Integrated Television Textile-Apparel Textile-Home Furnishings Textile-Products Theaters Therapeutics Tobacco Tools-Hand Held Toys Transactional Software Transport-Air Freight Transport-Equip&Leasng Transport-Marine Transport-Rail Transport-Services Transport-Truck Travel Services Venture Capital Veterinary Diagnostics Veterinary Products Vitamins&Nutrition Prod

1.00 NA 1.59 1.30 1.21 1.29 1.07 1.13 1.63 1.05 1.71 1.33 1.82 1.05 1.07 0.78 0.68 0.34 1.39 1.53 1.48 1.13 1.29 1.25 1.54 0.91 1.29 1.29 1.26 1.38 1.03 1.24 1.19 0.67 1.24 1.32 1.17 0.86 1.36 1.10 1.37 0.95 0.79 1.54 0.97 1.24 1.41 1.09 1.36 1.39 1.42 1.59

Water Water Treatment Systems Web Hosting/Design Web Portals/ISP Whsing&Harbor Trans Serv Wire&Cable Products Wireless Equipment Wool Wound,Burn&Skin Care X-Ray Equipment

1.11 1.41 1.46 1.52 0.95 1.44 1.54 NA 1.64 1.49


From Aswath Damodaran's web site,

Data Sets Historical Returns on Stocks, Bonds and Bills United States Download Excel file Download Archived Data

Implied Equity Risk Premiums - United States


Risk Premiums for Other Markets Levered and Unlevered Betas by Industry

Download 2000, 2001, 2002, 2003, 2004, 2005 , 2006 U.S. 1998, 1999, 2000, 2001, 2002, 2003. 2004 , 2005 , 2006

Marginal tax rate by country Total Beta By Industry Sector

Download Download 1998, 1999, 2000, 2001, 2002, 2003, 2004 , 2005 , 2006

Risk Measures by Market Cap Class Costs of Capital by Industry Sector

Download Download 1998, 1999, 2000, 2001, 2002, 2003 , 2004 , 2005 , 2006

Description This data set includes actual returns on stocks, bonds and bills for the United States from 1928 to the most recent year. It is a useful starting point for estimating historical equity premiums. These risk premiums are estimated based upon a simple 2-stage Dividend discount model and reflect the risk premium which would justify they current level of the index, given the dividend yield, expected growth in earnings and the level of the long term bond rate. These are risk premiums estimates for other markets based upon the country ratings assigned by Standard and Poors'. This data set lists betas by industrial sector. The betas are computed using 5 years of monthly returns for each stock and then averaged (simple). The unlevered betas are estimated using the average market debt/equity ratios by industrial sector. (Hamada betas). This is the KPMG survey of corporate tax rates by country. Please give them full credit when you use any of the information from this file. These are betas adjusted to reflect a firm's total exposure to risk rather than just the market risk component. It is a function of the market beta and the portion of the total risk that is market risk. These betas might provide better estimates of costs of equity for undiversified owners of businesses. These are risk measures - standard deviatiions, betas, total betas and hilo risk - broken down for U.S. firms into ten market cap classes. Make of it what you will. This data set lists costs of equity, costs of debt, market debt ratios and costs of capital by industrial sector.