Weighted Average Cost of Capital

Banikanta Mishra
XIM-Bhubaneswar
(Weighted Average) Cost of Capital
A company says that its current WACC is 20%.

What does this 20% Cost of Capital loosely mean?

For every $1 raised by the company now,

it has to pay out
(in form of dividends and interest)
$0.20 - or 20 cents - per year for ever

[Since we are talking about perpetual debt,

we are ignoring the par-value of the bond.]

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 Why is WACC Important?
Why is this 20% WACC relevant?

Because this also means that,

the company has to earn
at least 20 cents per $1 (or, 20%).

This is therefore called the “hurdle rate”.

Regulators call this the “fair return”.

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 How is WACC Computed?
WACC  WE RE  WD RD  WP RP

where RE , RD , and RP denote

respective RRRs on Equity, Debt, and Preferred-Stock

and WE , WD , and WP denote

respective weights on these three sources of financing

Two questions arise:

1) Why are we taking R, the Return or RRR, as the “Cost” of financing?
2) What are the weights – Ws - mentioned above?

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 Return as the Cost
1) Why are we taking R, the Return, as the “Cost” of financing?
What is RETURN from the investors’ perspective
is the COST from the firm’s perspective
(ignoring flotation or issuance costs)
Note: We should always take the CURRENT or MARGINAL Cost (RRR),
NOT the HISTORICAL Cost (or RRR)
For instance,
if our existing debt was issued two years back at a cost of 10%,
our Cost of Debt is not 10% now
We have to find out what it would cost us
if we issue debt TODAY

Caveat: Moreover, RRR depends NOT on the source of funds, but its use
(for instance, RRR of equity raised for investment in a risk-free project is Rf.)

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 Use Only Target Weights
2) What are the weights?
Ideally, these weights should be firm’s TARGET WEIGHTS based on market-values
(e.g. a firm may target to have 60% Equity, 30% Debt, and 10% Preferred OR target 2:1 Debt-Equity Ratio)

But if the Target Weights are not available, we can assume the following
E D P
WE  , WD  , and WP 
V V V
where E, D, and P denote, respectively, MARKET VALUES of Debt, Equity, and Preferred,
and, V, as usual, denotes the sum of these market-values (=> V = E + D + P)]

Note: If Market value of Debt and Preferred are not available,

we can take the book-values as surrogates
Caveat: Even when a project is financed with only debt or only equity,
the relevant RRR is still the WACC based on Target Weights,
NOT one based on 100% debt or 100% equity or on weights different from Target

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 Which WACC to Use?
WACC  WE RE  WD RD  WP RP
should be used to discount actual (or Levered) Operating CF

BUT, if we want to discount the UNLEVERED OCF

= OCF - Interest Tax Shield = OCF – (Interest x tc),
we should use
E D P
(Tax  adjusted) WACC  RE  RD (1  t c )  RP
V V V

where E/V is the Market-Value-based Target Weight on Equity,

and D/V and P/V are defined accordingly

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 WACC Variations
If Current Liabilities (CL) is an important financing source,
the firm should use the following WACC to discount unlevered CFs

E D P CL
WACC  RE  RD (1  t c )  RP  R CL
V V V V

If a firm is is financed with only Debt and Equity,

It should use the following WACC to discount unlevered CFs
D E
WACC  RD (1  t c )  RE
V V
This is often taken as the “default” WACC.

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Firm as a Portfolio of Two Divisions
For a firm with two divisions: X and Y,
A  wX X  wY Y
where a division’s weight represents
the fraction of firm-value accounted for by the division,
But, getting a division’s value is difficult,
and, therefore, so is its weight
Weight should be based on a stock concept (like NFA),
and NOT on a flow concept (like revenue or expense)
Correspondingly, the WACC of the company is
WACC  WX R X  WY R Y
where RX is the RRR for Division-X and RY for Division-Y

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 Divisional Cost-of-Capital
WACC is the appropriate discount-rate to value
a project as risky as the overall firm
BUT, when valuing a project for Division-X,
we should use RX as the discount-rate,
and similarly RY for Division-Y projects,
assuming that a project for a division
is as risky as the “division” itself
(that is, the typical project in the division)

But, how do we find out RX and RY?

Pure Play Approach: Look at “similar” firms
Subjective Approach: Fudge factor?
Similar means same business, same leverage (?)
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 Computing a Firm’s WACC: Practice
Required Data (Notice Overlaps):

DDM Growth-Rate in Dividends, Earnings, Prices

Most Recent Dividend and Share Price

COE
Historical Return on firm’s Stock and Market Index
(or eta of Firm’s Stock)
CAPM
Current Rate on Treasury (90-day / 1-year / …)
Historical Index-Treasury Spread
(that is. Rm – Rf for chosen Index and Treasury)
COD Coupon-Rate, Amount, Current Price of each Bond issue
Target Debt-Equity Ratio: Market-Value-based
WEIGHTS
(or Number of Shares Outstanding and Share Price,
Amount or Face Value of Debt for each past issue,
and current Bond Market-Price Quote for each issue)
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 Cost of Debt
Typically the Cost of Long-term Debt
We know COD = RRR = Rf + Risk-Premium
But, how do we compute it?
It is the Effective Yield or, for annual coupon, YTM
Suppose $1,000,000 Face-Value debt outstanding
Current Quote: 115 ( => Price is $115 per $100 Par)
Time to Maturity: 7 years
Coupon Rate: 10%, annual payments
Then, COD = Effective Yield = YTM = 7.20%
(recall how to use calculator for computing YTM)
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 Cost of Debt: A Caveat
COD is the Effective Yield on Debt,
which equals YTM for annual coupon-payments

Recall that YTM is

NOT the same as Current Yield OR Coupon Rate

In the previous example,

COD = Effective Yield = YTM = 7.20%
whereas Coupon Rate = 10% and Current Yield = 8.70%

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Cost and Value of Non-Traded Debt
What if the company’s debt does not trade publicly?
Then, we don’t have its price or value,
we cannot explicitly compute effective-yield
In such cases,
look at Effective Yield of debt of other “similar” firms
“Similar”  Similar in risk, rating, debt-ratio
(possibly same or similar line of business)

How to compute value of debt here?

Discount interest-payments and par-values by
the Cost-of-Debt obtained above to get debt value;
or else, take Book Value as substitute for Market Value
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 Computing Weighted COD
Though most firms typically have
one class of common shares,

They would have several issues of debt,

issued at different points of time in past,
with different times-to-maturity, coupon-rates

In such cases, we should compute

average Effective Yield (or YTM)

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 Market-Value and Cost of Debt
GIVEN DATA
Coupon Maturity Amount* Current-Price
9.00% 2010 $25 mil 101.28% (of par)
7.00% 2015 $75 mil 89.45%

DERIVED BY US
Coupon Market-Value* % of Total YTM
weight

9.00% $25.32 mil 27.40 8.50%

7.00% $67.08 mil 72.60 8.90%
Total  $92.40 mill Weighted Average  8.79%

* Multiplying Amount (or Total Face Value) by Price gives the Market-Value
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 Market-Value of Equity and Weights
Suppose the same Company has
one million shares outstanding,
each with a current price of $200
Then its Market Value of Equity =
$200 million
So, the Market-Value Debt-Equity-Ratio
= 92.40 / 200.00 = 46.20%
Moreover,
D 92.40
  31.60%
V 92.40  200.00
E
  100%  31.60%  68.40%
V
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 Two Approaches for Cost of Equity
1. DGM (Dividend Growth Model)
Easy to understand and use
BUT,
Does not explicitly take risk into account
AND
Difficult to estimate if
•Company not paying dividends
•Dividends not growing at a steady rate

2. CAPM (or SML)

It takes risk explicitly into account
BUT,

Measure of risk (Beta) varies over time

AND
Estimation is sensitive to various factors

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 DGM Approach
D t 1 D t (1  g) D t 1
Pt    RE  g
RE  g RE  g Pt
Looks familiar? R = DY + CGY
So, COE (Cost of Equity) = RE = RRR = DY + g
g, the growth-rate, is
Estimated from historical data
OR taken from analysts’ forecasts
Suppose a company, whose dividends have been growing steadily @5%,
has just paid a dividend of $4.00, and its price now is $20.00

What is the firm’s COE?

D t (1  g) 4.00 (1  5%)
COE  RE  g  5%  26%
Pt 20.00
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 CAPM or SML Approach
Ri = Rf + i (RM - Rf)
Need Three Variables:
Rf  Current Treasury Rate (easily available)
i  Obtained by regressing historical stock-return on market-return
(RM - Rf) Usually taken as equal to the “historical spread”

A company has a  of 1.25;

Current Rf (Treasury Rate) is 6.00%,
Historical RM - Rf Spread has been 8.00%

COE = Ri = Rf + i (RM - Rf) = 6% + (1.25 x 8%) = 16.00%

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 Cost of Preferred Stock
Typically a perpetuity,
sometimes may be a growing perpetuity
Generic Formula:
D t 1 D
Pt   RP  t 1  g
RP  g Pt
where g, the growth rate, is typically zero

A firm’s preferred-shares,
that have been paying $2.50 dividend annually,
are selling now for $20.00
D t 1 2.50
So, RP  g  0  12.50%
Pt 20.00

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