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

Example rD
A company has the following bonds
outstanding. What is its overall rD?
Coupon
(%)
6.375

Book
Market
Value ($m) Value ($m)
499

521

YTM
(%)
5.5

7.250

495

543

6.5

7.625

200

226

6.6

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

= _______

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

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

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

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 stocks beta is 1.1
What is the companys cost of common
equity according to CAPM?
rE = _______

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 companys rE according to
constant growth model?
rE = ________

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

Capital Structure Weights

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

Putting it together
From previous information, what is the
companys WACC?
Answer: WACC = ___________

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!

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 firms tax rate is 34
percent.
Compute IMCs WACC

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

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

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

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