The Weighted Average Cost of

Capital (WACC)

WACC

What precisely do the terms “cost of capital” and “weighted average

cost of capital” mean?

To begin, note that it is possible to finance a firm entirely with common

equity. However, most firms employ several types of capital, called

capital components, with common and preferred stock, along with

debt, being the three most frequently used types.

WACC

If a firm’s only investors were common stockholders, then the cost of

capital would be the required rate of return on equity. However,

most firms employ different types of capital, and, due to differences

in risk, these different securities have different required rates of

return. The required rate of return on each capital component is

called its component cost, and the cost of capital used to analyze

capital budgeting decisions should be a weighted average of the

various components’ cost which is called WACC or Weighted

Average Cost of Capital.

WACC Components; Cost of Debt

The first step in estimating the cost of debt is to determine the rate of

return debt-holders require (rD).

We should note that the required return to debt-holders, rD, is not equal

to the project’s cost of debt, because, since interest payments are

deductible, the government in effect pays part of the total cost. As a

result, the cost of debt to the firm is less that the rate of rD.

WACC Components; Cost of Debt

In summary the cost of debt for the project (firm) is the after tax cost of

debt. This is the cost of debt used to calculate WACC.

After Tax Cost of Debt = Interest rate – Tax Savings

)1( trstOfDebtAfterTaxCo D

WACC Components; Cost of Common Stock

Companies can raise common equity in two ways: (1) directly, by issuing

new share, and (2) indirectly, by retaining earnings. If new share are

issued, what rate of return must the company earn to satisfy the new

stockholders. This rate is the expected rate of return by equity holders

(rE).

WACC

WACC or Weighted Average Cost of Capital is the weighted average of

the cost of different capital components.

ED rED

Etr

ED

DWACC

)1(

Corporate Valuation and the Cost of Capital

Sales

Revenues

Operating

Costs

And Taxes

Required

Investments

In Operation

Financing

Decisions

Interest

RatesFirm Risk

Market

Risk

FCF (Free Cash Flow)WACC (Weighted

Average Cost of Capital)

Value of The Firm (Project)

nn

WACC

FCF

WACC

FCF

WACC

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WACC

FCF

)1(.....

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22

11

Present Value (Value)

The Statement of Cash Flow (C/F)

The Statement of Cash Flow tries to explain the reasons for the change

in cash between balance sheet dates. According to FASB, the

statements of Cash Flows should explain changes in cash and cash

equivalents. Cash equivalents represent short term, highly liquid

investments in which a firm has temporarily placed excess cash. In

other words, the statement of cash flows is the term used to refer to

flows of cash and cash equivalents.

The Statement of Cash Flow (C/F)

The Statement of Cash Flows classifies the reasons for the changes in

cash as operating, or investing, or financing activity.

The changes in the cash and cash equivalents during a period could be

result of operating, investing and financing activities which could

have different impacts on the long run ability of the firm or project to

provide cash.

Cash Flow from Operating (CFO)

Selling goods and providing services are the most important ways for a

financially healthy company to generate cash. Assessed over

several years, the cash flow from operation indicates the extent to

which operating activities generate more cash than they use.

A firm can use the excess cash flow from operation to acquire

buildings and equipments, pay dividends, retire long term debt, and

conduct other investing and financing activities.

Cash Flow from Operating (CFO)

Cash Flow from Operations (CFO) naturally includes cash collected for

sales and cash spent to generate sales. This includes operating

expenses such as salaries, rent and taxes. But notice two additional

items that reduce CFO: Cash paid for inventory and interest paid on

debt

Cash Flow from Investing (CFI)

The next section of the Statement of Cash Flows shows the amount of

cash flow from investing activities. The acquisition of non-current

assets, particularly property, plant, and equipment, usually

represents a major ongoing use of cash. A firm must replace such

assets as they wear out, and it must acquire additional non-current

assets if it is to grow. A firm obtains part of the cash needed to

acquire non-current assets from sales of existing non-current assets.

Such cash inflows seldom, however, cover the entire cost of new

acquisition.

Cash Flow from Investing (CFI)

Firms not experiencing rapid growth can usually finance capital

expenditures with cash flow from operations. Firms growing rapidly

must often borrow fund or issue common stock to finance their

acquisitions of non-current assets.

Cash Flow from Financing (CFF)

At last, a firm obtains cash from short and long term borrowing and

from issues of common or preferred stock. It uses cash to pay

dividends to shareholders, to repay short or long term borrowing,

and to reacquire shares of outstanding common or preferred stock.

These amounts appear as cash flow from financing activities in

the statement of cash flows.

Free Cash Flow (FCF)

Business terminology refers to an excess of cash flow from operations

over cash flow investing as free cash flow (FCF).

Firms can use free cash flow to repay borrowing, pay a dividend,

repurchase common stock, and add to cash on the balance sheet.

Free Cash Flow is the sum of Cash Flow from Operating and Cash

Flow from Investing.

FCF = CFO + CFI

The Statement of Cash Flows (C/F)

Cash Flow From Financing (CFF)

Cash Flow From Operating (CFO)

Cash Flow From Investing (CFI)

Free Cash Flow (FCF)

Cash Flow From Operating

Cash Flow From Financing

Free Cash Flow (FCF)