Weighted average cost of capital WACC

1
Weighted average cost of capital (WACC)

• Weighted average cost of capital is the expected
  return on a portfolio of all companys existing
  securities.

Rx denotes cost of capital wx denotes
portfolio weight
2
Weighted average cost of capital

• It is used as a discount rate for capital
  budgeting purposes.
• A companys cost of capital can be compared to
  the CAPM required return

3
CAPM and cost of capital

• For a project

SML
Required return
Cost of capital
Project beta
4
CAPM and cost of capital

• Cost of capital is not always the correct
  discount rate.
• Only if new project is the same risk as the
  firms existing business.
• Evaluate NPVs of different projects using the
  projects discount rate.

5
What happens if we use cost of capital approach
for projects with more/less risk than the firm?

• For a project

SML
Required return
Incorrectly accept
Cost of capital
Incorrectly reject
Project beta
6
Discount rate should be dependent on risk
7
Why use the cost of capital?

• Most projects are treated as average risk.
• Used as a starting point for riskier/safer
  projects.

8
Measuring the cost of equity

• Using CAPM
• Required return rf ß (rm rf)
• Where ß is calculated as

9
Standard error of beta

• A regression model of the CAPM for an individual
  firm will give us an estimate of ß, the
  coefficient of the market risk premium.
• It will also give us a standard error (or
  standard deviation) of this estimate.

10
Another measure for cost of equity

• Use the Dividend Growth Model approach (constant
  growth model)
• Cost of preferred stock

11
Cost of debt

• The cost of debt is the required rate of return
  on the firms outstanding debt.
• In other words, the yield of maturity.
• Calculate the yield on a companys long term
  bonds to find the cost of debt (Rd)
• Multiply by (1-t) since interest payments are tax
  deductible.

12
Weighted average cost of capital

• Remember,
• The weights are the capital structure market
  values divided by total assets
• wE Market value of equity (E)/firm value (V)
• wD Market value of debt (D)/firm value (V)
• wP Market value of pref stk (P)/firm value (V)

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Example

• Bauer, Co. has 8 million shares of common stock
  outstanding, .5 million shares of 6 preferred
  stock outstanding, and 100,000 9 seminannual
  bonds outstanding, par value 1,000 each. The
  common stock currently sells for 32 per share
  and has a beta of 1.15, the preferred stock
  currently sells for 67 per share, and the bonds
  have 15 years to maturity and sell for 91 of
  par. The market risk premium is 10 and T-bills
  are yielding 5. The tax rate is 35.

14
Example

• Calculate Bauers market value capital structure
• What rate should Bauer use to discount a
  projects cash flows if the new project has the
  same risk as the firms typical project?
• Bauer has a prospective investment that is the
  same risk as the firms typical project. The
  cash flows from the investment are as follows
  Year 0 -10,000 Year 1 150,000 Year 2
  50,000 Year 3 25,000. Should Bauer accept
  the project?

15
Example

• E 8M(32) 256M
• D 100,000(1000)(.91) 91M
• P 500,000(67) 33.5M
• V EDP 380.5M
• E/V .6728, D/V .2392, P/V 0.0880

16
Example

• RE .05 1.15(.10) 16.5
• RD YTM
• on calculator N 30, PV 910, PMT 45, FV
  1000. YTM 2(5.092) 10.18
• RP 6/67 8.96

17
Example

• WACC .6728(.1650) .2392(.1018)(1-.35)
  .0880(.0896)
• 13.47
• This should be used as the discount rate on the
  project.

18
Example

• Should the firm accept the project?
• Calculate the NPV of the cash flows using the
  WACC as the discount rate.