Calculating the Weighted Average Cost of Capital (WACC) for a Company For use in Conjunction with the Firm

Valuation Project

First ensure that you have read relevant pages in the text. Some important sections would include the following, but you may also double-check the references in the text by using the index [see: Cost of Capital and Target (optimal) Capital Structure, etc.]: The important Chapter in the text is the one entitled "The Cost of Capital," with a particular focus on the section entitled The Weighted Average Cost of Capital and the section Four Mistakes to Avoid at the end of the chapter. The WACC formula discussed below does not include Preferred Stock. Should your company use PS, be sure to adjust the equation for it, and see the section in the chapter on the Cost of Preferred Stock. The WACC formula that we use is: WACC = wdrd(1-T) + wsrs We need to know how to calculate: 1. rs the cost of common equity. Use the Security Market Line (SML) this is why you learn how to calculate a companys beta and also why you learn how to find the appropriate risk-free rate and market-risk premium. For a review, see the section the text, The CAPM Approach. 2. The weights (wd and ws note that: wd + ws = 1; so you only have to calculate one of them). We need to calculate the weight of debt and the weight of equity (for the cost of debt, this simply means: what proportion of the firms financing is by debt?). There is a lot to say here, simplified as Theory 1, Theory 2 and Practice:

a. Theory 1: Theory says that we should use the target weights along with the market values of both debt and equity (see the Four Mistakes to Avoid). But the market value of debt is typically difficult to calculate, because we need to know the YTM (which is rd) for all of the companys debt, but we cannot calculate the YTM without having the current prices of the companys outstanding bonds, and most companys bonds do not trade (i.e., they will not have up-todate or current prices remember how to calculate the price (value) of a bond on your calculators?!). As a result, at least for the group project, we go to Theory 2. b. Theory 2: Theory also says that we should use the TARGET weights, but this is a management decision, and as outsiders we do not have access to the thoughts of the CFO or CEO. So we should look instead to the historical pattern of the use of debt (mix of debt and equity), and this is one reason that you should have about 10 years of financial data. c. Practice: Since we cannot work according to the strict theory of finance, we have to estimate the relevant weights. As a result, we will use the formula: wd = Book Value of Debt / [Market Value of Equity + Book Value of Debt] The book value of debt is calculated by adding up ALL of the debt on the balance sheet. This will typically be the sum of Notes Payable, Current Portion of LT Debt and Long-Term Debt. The market value of equity is the Market Cap, and equals the number of (common) shares outstanding multiplied by the price/share. Note that the timing of this value should coincide with the book value of debt. For example, if you calculate the book value of debt as of 12/31/03, then the market cap should also be calculated for that date. Be very careful about using the reported Market Cap on [Link] it may not have the same timing.

By using this formula, you should be able to track the companys use of debt over many years. Finally here, you may also calculate the straightforward Debt Ratio(as defined in the text in the chapter on the analysis of financial statements), which would use the book value of common equity instead of the market value. This is not a recommendation to use that ratio for the WACC, but the Debt Ratio may be useful for comparison. 3. r d; the cost of debt. There may be more than one acceptable approach to calculate or estimate a companys cost of debt (be sure to read the text!). One relatively straightforward method is to discover the companys debt rating (e.g., by Moodys). This can usually be found on the companys 10K (see the link on my homepage) and doing a word search for rating or debt rating. For a discussion of bond ratings, see the text (look in the index). If you can find the debt rating for your company then you can carry out the following steps (if you cannot find a bond rating for your company, you might try to estimate/guess what it is by considering your companys beta and comparing the bond ratings for companies with similar betas). If you are not able to find a bond rating readily, you can register (for free) at Standard & Poor's and atMoody's to find company ratings. You may also find other interesting and useful information there. For a general discussion of what the ratings mean, see the information from these rating agencies on my homepage at the Bond Rating link. Once you have the actual bond rating or an estimate you can then find or estimate your companys cost of debt by going to [Link] and clicking on the Bonds/Rates link ([Link] Look at the yields for the 20 year Corporate Bonds by rating. If your companys bond rating is listed, youre in luck. If it is not listed then you can estimate the cost of debt. For example, if the AAA yield is 6.50%, the AA yield is 6.75% and the A yield is 7.00%, you can see a pattern (equation). For every increase in risk (from AAA to AA), there is a 0.25% increase in the yield. If your company has a BB rating, then it is two steps below the A rating, so you should add approximately 0.50% more to the 7.00% for the A rating, giving you a cost of debt for your company of about 7.50%. Note that this approach assumes a linear equation for the cost of debt (which may not be strictly true). 4. The corporate tax rate ( T ). Be sure to read the section in the text on Corporate Income Taxes (Chapter 2). The correct tax rate for a company is

the marginal tax rate for the future! If you expect your company to be very profitable for a long time into the future, then the tax rate ( T ) for your company should probably be the highest marginal tax rate applicable for corporations. But there are times when companies can obtain long-term tax breaks so that their tax rates may be lower than the stated (regulated) tax rate. Consequently you may want to calculate several/many historical effective tax rates for you company. The effective tax rate is the actual taxes paid divided by earnings before taxes (on the income statement). You can calculate/consider these rates for the past 5-10 years and then compare this effective tax rate to the legally mandated highest marginal corporate tax rate. If the past historical effective rate is lower than the marginal tax rate, there may be a good reason for using that lower rate in your pro formas.
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WACC - Weighted Average Cost of Capital

Corporations create value for shareholders by earning a return on the invested capital that is above the cost of that capital. WACC (Weighted Average Cost of Capital) is an expression of this cost and is used to see if certain intended investments or strategies or projects or purchases are worthwhile to undertake. WACC is expressed as a percentage, like interest. So for example if a company works with a WACC of 12%, than this means that only (and all) investments should be made that give a return higher than the WACC of 12%. The cost of capital for any investment, whether for an entire company or for a project, is the rate of return capital providers would expect to receive if they would invest their capital elsewhere. In other words, the cost of capital is an opportunity cost. How can the Weighted Average Cost of Capital (WACC) be calculated? The easy part of WACC is the debt part of it. In most cases it is clear how much a company has to pay their bankers or bondholders for debt finance. More elusive however, is the cost of equity finance. Normally, the cost of equity finance is higher than the cost debt finance, because the cost of equity involves a risk premium. Calculating this risk premium is one thing that makes calculating WACC complicated. Another important complication is which mix of debt and equity should be used to maximize shareholder value (This is what "Weighted" means in WACC). Finally, also the corporate tax rate is important, because normally interest payments are tax-deductible. Formula WACC Calculation

debt / TF (cost of debt)(1-Tax) + equity/ TF (cost of equity) --------------------------------------------------------WACC In this formula, * TF means Total Financing. Total Financing consists of the sum of the Market values of debt and equity finance. An issue with TF is whether, and under what circumstances, it should include current liabilities, such as trade credit. In valuing a company this is important, because: a) trade credit is used aggressively by many companies, which in turn affects their business credit, b) there is an interest (or financing) charge for such use, and c) trade credit can be quite a large sum on the balance sheet. * Tax stands for the Corporate Tax Rate. Example: suppose this company: The Market value of debt = 300 million The Market value of equity = 400 million The Cost of debt = 8% The Corporate Tax rate = 35% The Cost of equity is 18% The WACC of this company is: 300:700*8%*(1-35%) + 400:700*18% --------------------------------------------------------12,5% (WACC - Weighted Average Cost of Capital) Compare: IRR | Net Present Value | DCF More valuation methodologies

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Corporate Finance Basics

How do I calculate WACC?

In order to calculate a weighted average cost of capital there are a few pieces of information that we need to know: TheWd= The proportion of the financing taken on by debt (amount of capital taken from loans/initial investment)

The Wpfd= The proportion of the financing taken provided by preferred stock (amount of capital taken from preferred stock/initial investment) The We= The proportion of the financing provided by equity (amount of capital raised by new equity/initial investment) The after tax Kd= The cost of debt x ( 1- tax rate) or the interest rate that the bank requires The Kpfd= dividend/share price The Ke= R(r)+ Beta (Market Risk Premium) The initial investment The tax rate We are now able to calculate the WACC which =

Wd(Kd)(1-t)+(Wpfd)(Kpfd) +(We)(Ke)
Here is a numerical example: We want to start a company that requires an initial investment of $100,000. Our company that will manufacutre plastic shower caddies will require use of all $100,000. We are able to take out a loan of $25,000 from a local bank; $50,000 by issuing common stock to family, friends, and professors; and $25,000 of preferred stock to a generous alumna of MHC. There is an 8% interest rate on our loan; and we agreed to pay our alumna 6% return. We do some research and see that a company who only manufactures plastic shower caddies has a beta of .85 with no outstanding debt. Our risk free rate is 4.4% and market risk premium is 6.6%. The tax rate is 30%. What is our required return on our investment that we will use to find a present value of our company, in other words, our WACC?

SOLUTION:
Wd= 25,000/100,000 = .25

We= 50,000/100,000 = .5 Wpfd= 25,000/100,000 = .25

Kd= .08 Ke= .044+.85(.066) = .10 Kpfd= .06

Now we can substitute into our equation: WACC= (.25)(.08)(1-.3)+(.5)(.1)+(.25)(.06)

WACC= .014+.05+.015 = .079 = 7.9%

When finding a rate of return for an individual project, we must remember that WACC is only appropriate for an individual project when its risk is equal to the risk of the company as a whole. If there is added or subtracted risk to the firm from the project, the required return must be adjusted.

A new Beta for the project must be found by using the Hamada Equation:
Beta of assets= Beta of equity/ [1+(1-t)(D/E)] Then a new return can be calculated using this new Beta: Risk Adjusted Discount Rate= risk free rate+ (beta of assets)(market risk premium) Why Calcluate WACC?
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This website was created in May 1999 byAlison Hirsch '01, and is maintained by Professor Satya Gabriel, of the Economics Department atMount Holyoke College