Weighted Average Cost of Capital

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?

10. 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 = _______

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 $62.50. 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