1. Weighted Average Cost of Capital
(WACC)

2. 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

3. Assets
Debt
Preferred Stock
Common Stock

4. 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

5. WACC Formula
It is important to understand the inputs to the WACC formula

6. 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

7. 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

8. 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

9. Example rD
A company has the following bonds outstanding. What is its overall rD?
Coupon
(%)
Book Value ($m)
Market Value ($m)
YTM
6.375
499
521
5.5
7.250
495
543
6.5
7.625
200
226
6.6

10. Example rD Total market value of bonds: 521 + 543 + 226 = $ _______
Weights of each bond issue: 521/____ 543/____ 226/____ = ____ =____ =____
Overall rD =___ x ___ x ___ x = _______

11. Cost of Preferred (rP) Use perpetuity formula:
D is the annual dividend on preferred stock
P0 is the latest preferred stock price

12. Example rP
The company has 1 million shares of 8% preferred stock selling for $120 today. What is rP?
rP = _____ / _____ = ______
Note: 8% preferred means the company pays a preferred dividend of 8% of its par value which is always $100

13. Cost of Common Equity (rE)
rE can be estimated in one of two ways:
CAPM equation: rE = Rf + [E(Rm) – Rf] x β OR
Constant growth formula: rE = D1/P0 + g

14. 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 $ T-bills yield 5%, the market risk premium is 6%, and the stock’s beta is 1.1
What is the company’s cost of common equity according to CAPM? rE = _______

15. Example rE
The same company just paid a dividend of $5 and analysts estimate that the dividends will grow at 4% rate forever.
What is the company’s rE according to constant growth model? rE = ________

16. Note on rE
Most companies do not have dividends growing at a constant rate forever
It is better to use CAPM equation to estimate the cost of common equity
You must use one of the two methods to estimate rE
Use caution when using constant growth method

17. Capital Structure Weights
From previous information compute:
D/V = ____ / ____ = _____
P/V = ____ / ____ = _____
E/V = ____ / ____ = _____
Assume marginal corporate tax rate (T) of 40%

18. Putting it together…
From previous information, what is the company’s WACC?
Answer: WACC = ___________

19. 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!

20. Another Example
Independence Mining Corporation (IMC) has 7 million shares of common stock outstanding, 1 million shares of 6 percent preferred outstanding, and 100,000 $1,000 par, 9 percent semiannual coupon bonds outstanding. The stock sells for $35 per share and has a beta of 1.2, the preferred stock sells for $60 per share, and the bonds have 15 years to maturity and sell for 89 percent of par. The market risk premium is 5.5 percent, T-bills are yielding 6 percent, and the firm’s tax rate is 34 percent.
Compute IMC’s WACC

21. Example continued
If IMC is evaluating a mining expansion project that is as risky as the firm’s typical project, what rate should they use to discount the project’s cash flows?
If IMC is thinking of going into shipping business, can it use the current WACC to discount the shipping project’s cash flows?

22. 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

23. 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)

24. Recap We started with TVM
We always compare cash flows occuring at different times at the same point in time
compare apples with apples
Value of ANY asset is simply the PV of ALL future cash flows
For TVM you need cash flows and ‘r’

25. Recap Cash flows for different assets have different names:
For Stocks: cash flows are dividends
For Bonds: cash flows are interest/principal
For Projects: cash flows are project cash flows
Cash flows often need to be estimated

26. Recap
‘r’ (in general, interest rate or discount rate) has different names for different assets:
For Stocks: required rate of return
For Bonds: yield
For Projects: cost of capital
‘r’ always depends on the riskiness of cash flows
according to CAPM, risk is measured by beta
more the risk the higher is ‘r’

27. 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