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
7.625

495
200

543
226

6.5
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 Common Equity (rE)

rE can be estimated in one of two ways: CAPM equation: rE = Rf + [E(Rm) Rf] x

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 stocks beta is 1.1 What is the companys cost of common equity according to CAPM? rE = _11.6%______

Capital Structure Weights

From previous information compute: D/V = ____ / ____ = _____ E/V = ____ / ____ = _____ Assume marginal corporate tax rate (T) of 40%

Putting it together
From previous information, what is the companys 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!

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)

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