Introduction to the WACC concept

Copeland, Ch. 15

Copeland, T.; Weston, J. F. & Shastri, K. (2005) Financial Theory and corporate policy. 4th Edition. Pearson Addison
Wesley: Boston, MA. ISBN 0-321-12721-8

Investors
Firms has different
sources of funds
Funds from investors
facing different type of
risks

Debt

Two basic claimants

Contracts
(bonds)

Equity
Internal
(retained)

Convertible debentures
Preferred stocks

External (New
shareholders)

Leases
No voting stocks
Other
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Prof. John Rosso, Ph. D.

Cost of Capital
Investors has the rights to decide in which projects the firm
should invest
Each project must compensate the investors according with
their risk
The Cost of Capital: is the minimun risk adjusted rate of
return that a project must earn in order to be acceptable to
shareholders (Copeland, 2005 p. 557)
Shareholders require the rate of return of new projects to be greater
than the cost of funds provided by them and bondholders
In other words, the marginal increase in the value of the firm should
be greater the marginal increase of the investment

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Prof. John Rosso, Ph. D.

Modigliani & Miller (1958, 1963)

Assumptions
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

Capital markets are frictionless

There is a risk free rate
No financial distress costs
Two claimants: equity and debt
Al firms in the same risk class
No growth
Information symmetry
No agency costs
CF are not affected by capital structure
When taxes, they are just corporate

02/05/2016

Prof. John Rosso, Ph. D.

Value of a Firm
The value depends on the future cash flow. We value this
CF by discounting it at the appropriate risk-adjusted
rate:
By assumption 6 then:

where:

means the value of the unlevered firm

is the discount rate for the risk class
is the expected value of the perpetual Free Cash Flow

The FCF is (1 ) plus no monetary accounts:

1 +

02/05/2016

Prof. John Rosso, Ph. D.

Value of a Firm
Provided that there is no growth, in order to keep the same
amount of capital in plaace, it is required that Dep=I, then:
=
1 +

Thus,

=
1

What is the same Net Operating Income after taxes (NOPAT)

But, if the FCF is a perpetuity,

=
1 :
It can be written in alternative ways:

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1


=
=

Prof. John Rosso, Ph. D.

Value of a Firm with debt

If the firm issues debt, shareholders will receive the FCF and
bondholders the interest on debt:
+ + =

1 +

But = ,

1 +
+ =

The first part is the FCF, and it is discounted at the rate ; the second
part is discounted at the after tax rate (since it is risk-free).
Therefore:
1


+
=

Where = (market value of the debt)

02/05/2016

Prof. John Rosso, Ph. D.

Value of a Firm with debt

= +

Where is the debt tax shield.

If = 0 = , what is exactly the Modigliani

& Miller proposition I:

The market value of a firm is independent of its

capital structure and is given by capitalizing its
expected return at the rate appropriate to its risk
class

In other words, the method of financing is irrelevant

02/05/2016

Prof. John Rosso, Ph. D.

The Weighted Average Cost of Capital

As stated before, an investor requires increasing her wealth:

=
+

As is required that

> 1, so it is:

+
>1

> 1

The left hand is the change in the FCF due to a change in the
investment I, or the project return. The right hand is the
opportunity cost for the project.
02/05/2016

Prof. John Rosso, Ph. D.

WACC
From here:

= 1

If a firm has a long run target debt ratio, say / , then:

=

The question is about the denominator, what value?

In M&M it is the replacement value (all the investments to put the project in
place)

From this concept, an alternative WACC is defined as:

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= 1

Prof. John Rosso, Ph. D.

10

The cost of equity

The return of the new investment for shareholders is:

+ S n

S 0

Provided that:

NI k d D 1

+
=
+

I
I

NI k d D 1
+
= 1
I

1

+
= + =

NI k d D 1
+

= I
+
I

But:

S 0 + S n
=
+
I

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Prof. John Rosso, Ph. D.

11

The cost of equity

S 0

S 0

S n

S n

NI k d D 1
+

I
I
+
=
+

kb B

NI + 1 k
d D +
=

S 0 + S n = NI + 1 = NI 1

+
1

S 0 + S n
S 0 + S n

But S 0 + S n = S, then = , and therefore:

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= + 1
Prof. John Rosso, Ph. D.

12

Graphical presentation
(a) Assuming = 0

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(b) Assuming > 0

Prof. John Rosso, Ph. D.

13

Alternative WACC
In graphical representation the equation is written as
/ not /. This is true when the firm has a long run
target debt ratio /
The usual definition of Weighted Average Cost of
Capital is to weight the after-tax cost of debt by the
percentage of the debt in the firms capital structure and
add the result to the cost of equity multiplied by the
percentage of equity. The equation is:

= 1
+
+
+

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Prof. John Rosso, Ph. D.

14

Consistency
Provided that:
= + 1

Replacing in the equation of WACC:

= 1
+ + 1
+
S +

= 1
+
+ 1
1
+
+
+
+

=
+

+
+
+

= 1
+
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Prof. John Rosso, Ph. D.

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