FIN 614: Financial Management

Larry Schrenk, Instructor

Video 31 (Topic 6.5):The Weighted Average Cost of Capital (WACC)

Topics

1. Determining the Weights

2. A Complete Example

3. Using WACC for Valuing…1. Internal Divisions2. Projects

Weighting the Sources of Capital

d c pd p s sWACC r (1– ) rw w rw

Weights represent the percentage raised by each source of financing:

d

p

s

Debtw =

Firm ValuePreferred Stock

w = Firm Value

Common Stockw =

Firm Value

Two Possible Goals:Firm as Currently FinancedWACC as Discount Rate for Project

DecisionsFirm versus Project Weights Book versus MarketPast versus FutureActual versus Target

Weighting Objectives

Factors Influencing WACC

Uncontrollable Factors:Market Conditions, especially Interest RatesMarket Risk PremiumTax Rate

Controllable Factors:Capital Structure PolicyDividend PolicyInvestment Policy

Firms with riskier projects generally have a higher cost of equity

Investment AmountsCommon Stock = $50,000

Bonds = $25,000Preferred Shares = $25,000

Bond Price = $990Coupon Rate = 8%Period = SemiannualMaturity = 25 YearsPar Value = $1,000

WACC ExamplePreferred Stock

Price = $85Dividend = $8

Common StockRisk-Free Rate (rf) = 5%Return on Market (rM) = 12%Beta (b) = 1.1

Corporate Tax Rate tc = 35%

1. Calculate Weights, wd, wp, ws

2. Calculate Cost of Equity Capital, rs, using CAPM.

3. Calculate Cost of Preferred Capital, rs, using Market Implied Discount Rate

4. Calculate Cost of Debt Capital, rd, using YTM.

5. Calculate WACC.

WACC Example Overview

WACC Example: Weights

d

p

s

Debt 25w = =

Debt + Preferred Stock + Common Stock 50 25 25Preferred Stock 25

w = = Debt + Preferred Stock + Common Stock 50 25 25

Common Stock 50w = =

Debt + Preferred Stock + Common

25%

25%

Stock 50

25 2550%

Price = $990Coupon Rate = 8%Period = SemiannualMaturity = 25 YearsPar Value = $1,000

Yield to Maturity (YTM)

N = 50; I% = 8.09%; PV = -990; PMT = -40; FV = -1,000; P/Y = 2

WACC Example: Cost of Debt

Price = $85Dividend = $8

Implied Discount Rate

WACC Example: Cost of Preferred Stock

pp

d d 8.00V =

r V 859

00%

..41r

rf = 5%rM = 12%b = 1.1

CAPM

WACC Example: Cost of Common Stock

5 1.112 5 12.70%

i f mE r r E r r

wd = 0.25; wp = 0.25; ws = 0.50rd = 8.09%rp = 9.41%rs = 12.70% tc = 35%

WACC Example: Result

d d c p p s sWACC = w r (1– ) + w r + w r

= 0.25 0.0809 1 0.35 0.25 0.0941 0.50 0.1270

= 0.0131 + 0.0235 + 0.0 16 035 = .01%

Firm WACC and its Divisions

Composite WACC reflects the risk of an average project undertaken by the firm.

Different divisions may have different risks.

The division’s WACC should be adjusted to reflect the division’s risk and capital structure.

The Risk-Adjusted Divisional Cost of Capital

Estimate the cost of capital as if division were a stand-alone firm.

Estimating the division’s beta, cost of debt, and capital structure.

Pure Play Method

Find several publicly traded companies exclusively in division’s or project’s business.

Use average of their betas as proxy for project’s beta.

Hard to find such companies.

Accounting Beta Method

Regression between project’s ROA and S&P Index ROA.

Accounting betas are correlated (0.5 – 0.6) with market betas.

Problem: Data on new projects

Divisional Cost of Capital Using CAPM

Target Debt Ratio = 10%rd = 12%rrf = 5.6%tc = 40%bdiv = 1.7Market Risk Premium = 6%

Divisional Cost of Capital Using CAPM

Division Required Return on Equity:rs = rrf + bdiv(rM – rrf)

rs = 5.6% + 1.7(6%) = 15.8%.

WACCdiv = wd rd(1 – tc) + wsrs

= 0.1(12%)(0.6) + 0.9(15.8%)= 14.94%

Division WACC vs. Firm WACC

Division WACC = 14.9% versus company WACC = 10.4%

‘Typical’ projects within this division would be accepted if their returns are above 14.9%.

The Risk and Financing of a Project

If project has same financing and risk as the existing business or assets of the firm, use WACC as our discount rate

If the new project has very different financing or risk from existing business,

WACC must be adjusted (if possible), or

Use alternate method to find discount rate

Misusing WACC for All Projects: Example

What would happen if we use the WACC for all projects regardless of risk?

Assume the WACC = 15%

Project Required Return Expected Return A 20% 17% B 15% 18% C 10% 12%

Using One WACC for All Projects

You tend to favor more risky projects

Mistakenly reject project C and take project A

In making such mistakes, the firm becomes more and more risky.

Consider the Project Financing and Risk If the project is more (less) risky than the firm, use a discount rate greater (less) than the WACC

If the project has different financing than the firm, adjust the weights

IMPORTANT: If project weights are significantly different than the firm’s, then this may change required rates of return.

FIN 614: Financial Management

Larry Schrenk, Instructor

Video 31 (Topic 6.5):The Weighted Average Cost of Capital (WACC)