TOPIC: WEIGHTED AVERAGE COST OF CAPITAL (WACC)• Firm Value should be Maximized

when WACC is Minimized

• Factors that impact on WACC include operating profitability, business risk, interest rates at specified debt levels, and the tax rate

1RW Melicher

ADJUSTED PRESENT VALUE (APV)

• APV is often used to estimate the impact of using financial leverage

• APV = present value (PV) of an all equity firm + PV of tax benefits from debt – financial distress or bankruptcy-related costs

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APV EXAMPLE

• PV of All Equity Firm: future free cash flows to equity discounted by the cost of equity capital (e.g., $7 million)• PV of Tax Benefits: perpetual debt amount x

tax rate (e.g., $2 million x .40 = $.8 million)• PV financial distress costs (e.g., est. $.1

million)• APV = $7 mill. + $.8 mill. - $.1 mill. = $7.7

mill. 3

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A. DETERMINE PERCENTAGE WEIGHTS FOR DEBT & EQUITY IN THE CAPITAL STRUCTURE

1. Capital Structure Value (V)

V = Long-Term Debt (D) + Equity (S)

2. Current Versus Target Capital Structures

3. Market Value-Based Weights Versus Book

Value-Based Weights

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B. DETERMINE AFTER-TAX COSTOF EACH CAPITAL STRUCTURE COMPONENT (kd and ks)

C. ESTIMATE THE WACC FOR

SPECIFIED CAPITAL STRUCTURE

WACC = D/V(kd)(1 - tax rate) + S/V(ks) Where “V” is “D” + “S”

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D. COST OF DEBT CAPITAL: USE OF BOND RATINGS

1. Investment Grade Debt (Aaa, Aa, A, & Baa)

[Estimate the bond rating and determine the

market interest rate for that bond rating.]

2. High-Yield (“Junk”) Bonds (Ba or lower

bond ratings)8

E. COST OF COMMON EQUITY CAPITAL

1. The CAPITAL ASSET PRICING MODEL (CAPM) APPROACH

[CAPM describes the relationship between required rates of return and risk on assets held in well-diversified portfolios]

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2. SECURITY MARKET LINE (SML) DEPICTS RISK AND RETURN ON INDIVIDUAL SECURITIES

ks = krf + (km - krf)Bs

Where: krf is the risk-free rate, km is the expected rate of return on the market and Bs is the stock’s beta coefficient (index of systematic or relative market risk)

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a. Estimating the Average Annual Market Risk Premium (MRP)

Market Risk Premium = [km - krf]

[Estimate the future MRP by first determining an average historical MRP. Then, adjust the historical MRP if the future returns are expected to differ from historical average expectations.] 13

b. Business Risk

[Unlever Equity Beta (the observed Beta, BL) to get to the Asset Beta (BU) which reflects business risk]

BU = BL/[1 + D/S(1 - tax rate)]

Where “D” is debt and “S” is equity

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c. Financial Risk

[Relever the Asset Beta (BU) to reflect the new capital structure and the new Equity Beta (BL)]

BL = BU[1 + D/S(1 - tax rate)]

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d. New Cost of Common Stock

[Use new Beta estimate to re-estimate the ks using the SML]

ks = krf + (km - krf)Bs

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