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copyright anbirts1 Weighted Average Cost of Capital WACC

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copyright anbirts2 WACC The Capital of a company or organisation is made up of two elements Long Term Debt and Equity To find the WACC we simply weight the cost of each by its proportion in the total

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copyright anbirts3 WACC The cost of Debt is easy to find out We ask a bank (NB It is the after tax cost of Debt that we need) The cost of Equity, as we have discussed is trickier

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copyright anbirts4 WACC – An Example Company A has 50% of its capital in Equity and 50% in Debt Cost of Debt is 7% Tax rate is 25% Risk Free Rate is 5% Premium on the risk free rate is 4% Company Beta is 1.4575

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copyright anbirts5 WACC - Calculation Debt {7 (1-.25)}= 5.25 x.5 = 2.63 Equity ER A = R F + (ER M – R F )B 5 + (9 - 5)1.4575 =10.83 x.5 = 5.42 WACC 8.05

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copyright anbirts6 WACC This assumes steady state i.e. same risk, same financing and so on What if we are doing something new? Problems - No history, no Beta - We need a proxy

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copyright anbirts7 WACC - Proxy When using a proxy we need to be careful How close is it in Business risk and Experience terms? How close is it in Financial risk terms?

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copyright anbirts8 WACC –Adjusting for Financial Risk Using a leveraged or geared proxy If we intend to finance our project using different proportions of Debt and Equity to those used by our proxy company we have to adjust the proxy Beta to account for the difference in Financial risk

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copyright anbirts9 WACC –Adjusting Proxy Beta Two equations No 1. To un-lever a levered proxy B JU =. B J. [ 1 + D (1-T C )] E B JU = un-leveraged beta, B J = leveraged beta D/E = Debt Equity ratio, T C = Tax rate

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copyright anbirts10 WACC –Adjusting Proxy Beta No 2. To lever an un-levered beta B J = B JU [ 1+ D (1-T C )] E

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copyright anbirts11 WACC –Adjusting Proxy Beta Example Proxy company beta = 1.3 Proxy company tax rate = 25% Proxy company D/E =.3 Our Company tax rate = 25% Our intended D/E =.5

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copyright anbirts12 WACC – Adjusting Proxy Beta Example BJU = 1.3 = 1.3 = 1.061 1 +.3(1-25) 1.225 BJ = 1.061[1+.5(1-.25)] = 1.4575

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