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

Cost of Preferred (rP)

D rP P0
Use perpetuity formula:
D is the annual dividend on preferred stock P0 is the latest preferred stock price

Cost of Common Equity (rE)

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

OR
Constant growth formula: rE = D1/P0 + g

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

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 operation, 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)

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

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

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