AFM 373

Lecture 8
Weighted Average Cost of
Capital (WACC)

ACC 690 Course Overview

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.

Introduction; Managing C/A; Cash Flow Forecasting

Managing C/L; Issuing Short Term Debt & ABL
Issuing LTD; Debt Ratings; Debt Covenants
Issuing Equity; IPOs, PE, VC
Wtd. Average Cost of Capital; Determining Capital Structure
Valuation Overview; Intro to M&A
Mergers & Acquisitions - Structure; Leveraged Buyouts
Mergers & Acquisitions - Process; Due Diligence
Capital Budgeting; Lease vs. Buy/Borrow
Financial Distress & Turnarounds
Financial Risk Management & Derivative Use
Dividend & Payout Policy; Managing Corporate Investments
2

Weighted Average Cost of Capital

(WACC)

The weighted average cost of capital (WACC)

serves three primary purposes:
1. To evaluate capital project proposals.
2. To set performance targets for management to
sustain or grow market values, and
3. To measure management performance.

Steps in Solving for the WACC

1. Identify the sources of capital (Debt and Equity).
2. Estimate the market values for each source of
capital and determine the market value weights.
3. Estimate the marginal, after-tax, and afterfloatation cost for each source of capital.
4. Calculate the weighted average.

What is Included in WACC ?

Cost of Each Type of Capital for the Company,
proportionally weighted, typically including:
Debt Costs:
Bank loans
Long-term debt bonds/debentures

Equity Costs:
Preferred equity costs
Common equity costs

Weighted Average Cost of Capital - WACC

E
D
PS

WACC K e
Kd
K ps

D E PS
D E PS
D E PS
Need to calculate for each type of capital:
1) market value of each type of capital
2) % of each type of capital in total capital,
3) and the respective marginal cost of each (Kd , Ke, K ps)

Why Use Current Market Rates for

each Type of Capital?
The Firm is making a Key Decision NOW
Therefore, the cost of capital 5 months, 5 years or
5 decades ago is irrelevant.
What is relevant NOW is the rate that each type of
capital costs in todays economic environment for
this particular firm.
Sometimes called the Marginal Cost of Capital

Cost of Debt - Kd
This is the current cost to the firm for borrowing
funds based on:

Current interest rate levels

Default risk of company
Tax Shield from Interest
8

Importance of Tax Deductibility of Interest

Key Concept:
in WACC equation Kd - is after tax cost of debt,
reflecting that interest is tax deductible

Therefore Kd = rd(1-t)
Where:
rd= pre-tax cost of Debt
t = Marginal tax rate of the firm( Fed+ Prov.)
9

WACC- Simple Capital Structure

Once you have the specific marginal costs of capital (after accounting for taxes
and floatation costs) and you have found the appropriate weights to use, the
actual calculation of a WACC is a simple matter.

S
D
WACC K a K e K d (1 T )
V
V
The cost of equity
times the market
value weight of
equity

The cost of debt

after tax times the
market value weight
of debt

Weighting Each Capital Component

Each Type of Equity would have its own
weighting component
Each Types of Debt would have its own
weighting component

WACC - Spreadsheet Example

(1)

Type of
Capital
Long-Term Debt
Preferred Stock
Common Stock

(2)

(3)

(4) = (2)*(3)

Specific
Marginal Cost
Weighted
after tax and Market Specific
floatation
Value
Marginal
costs
Weights
Cost
5.5%
11.4%
12.9%

43.0%
11.0%
46.0%
WACC =

0.02365
0.01254
0.05934
9.55%

WACC is the sum of the weighted

specific marginal costs of each source of
capital.

Determining - Current Market Value

of a Bond
Requires market value of debt (not book value)
Coupon face value of bond
Mkt Value of Corporate Bond

t
N
t 1 (1 r )
(1

r
)
d
d
tN

rd =

the market rate of debt given default risk (not necessarily

the coupon rate, but the current market rate for that company to issue at)

This is the rate that you discount back the cash flows at.

13

Cost of Preferred Equity

If viewed preferred as perpetual, has a fixed dividend,
(PV of a perpetuity formula)
Preferred Share dividends are paid from after tax
dollars - (do not tax effect the rate)
K ps

dividend per share (or total dividend)

market price of pref

14

Market Value of Common Equity

For a Public company:
= # of common shares O/S X current stock price
If there are warrants and options, ( in the money) you
must calculate the equity like options current market
value and add to common equity value

15

Market Value of Common Equity

Cost of Equity may be observable in the Market, through
comparable securities.
Various models can be used to estimate Cost of Equity.
We will emphasize Capital Asset Pricing Model
(CAPM). According to some studies 80%+ use this method.

Originated by Prof. William Sharpe, Stanford U. in 1964

For his work on CAPM, Sharpe shared the 1990 Nobel Prize
in Economics with Markowitz and Miller.
16

Capital Asset Pricing Model (CAPM)

[calculating the Ke]

K j RF ( E( RM ) RF ) j
Risk Free Rate
Expected Rate of Return or E(Re)

Market Risk Premium

RM= Expected Return on Market
Systematic risk of individual security - tendency of
the security to move with all the other securities in the market and by how
much
17

Risk-Based Models and the Cost of

Common Equity
Using the CAPM to Estimate the Cost of Common Equity

CAPM can be used to estimate the required return by

common shareholders.
It can be used in situations where DCF methods will
perform poorly (growth firms)
CAPM estimate is a market determined estimate
because:
The RF (risk-free) rate is the benchmark return and is measured
directly, today as the yield on 91-day T-bills
The market premium for risk (MRP) is taken from current market
estimates of the overall return in the market place less RF (ERM
RF)

Risk-Based Models and the Cost of Common

Equity
Using the CAPM to Estimate the Cost of Common Equity

As a single-factor model, we estimate the common shareholders required

return based on an estimate of the systematic risk of the firm (measured by the
firms beta coefficient)

[ 20-26]

K e RF MRP e

Where:
Ke = investors required rate of return
e = the stocks beta coefficient
Rf = the risk-free rate of return
MRP = the market risk premium (ERM - Rf )

Risk-Based Models and the Cost of

Common Equity
Estimating the Market Risk Premium

[ 20-26]

K e RF MRP e

Rf is observable (yield on 10+ year Govt Bonds)

Not T-bill rates
Getting an estimate of the market risk premium is one of the
more difficult challenges in using this model.
We really need a forward looking of MRP or a forward looking
estimate of the ERM

One approach is to use an estimate of the current, expected MRP

by examining a long-run average that prevailed in the past.

Canadian Market Risk Premium

(MRP)
(1938-2005)
Average
Investment

Return

Canada T-Bills

5.20%

Canada Bonds

6.62%

Canadian Stocks

11.79%

U.S. Stocks

13.15%

Stock returns exceeded Bond returns by 5.17%

Source: Booth & Cleary ; data from Canadian Institute of Actuaries

The consensus is that the Canadian MRP over the

long-term bond yield is between 4.0 and 5.5%.
21

Cost of Common Equity

Estimating Beta
After obtaining estimates of the two
important market rates (Rf and MRP), an
estimate for the company beta is required.
In some cases, Beta may have to be
unlevered and re-levered?
Why ?

Unlevering and Re-levering Beta

If the debt level changes dramatically, beta for
Equity may have to be re-calculated.
For example, a significant new Debt issuance, or a
large Debt repayment.

Why ?
The main impact of leverage on WACC is the
interest tax shield.

Unlevering and Re-levering Beta

We can unlever and relever Beta using the Hamada
Equation (there are several others that serve the
purpose).
Hamada essentially combined the effects of CAPM
with M&M theory.
Assumes constant amount of debt (vs. constant D/E)
It separates out the effect of financial leverage from
the underlying business risk of the firm by comparing
a firm with an unlevered counterpart.

Unlevering and Re-levering Beta

an Example going from D/E of 1.5 to 4.0
( assume a 35% Tax rate)
BL =BU * (1+ (D/E*(1-T))
BU = BL / (1+ (D/E*(1-T))

If Original D / (D+E) =.60

Then D / E= .60 /.40 (i.e. 1.5:1)
Original Levered Beta = 1.25
Then Bu = 1.25 / 1+(60/.40) *(1-.35)
Bu= 1.25 / 1.975
Bu=.63

Re-levering Beta- Example

Going from D/E of 1.5:1 to 4:1
with 35% Tax Rate
BL =BU (1+ (D/E)*(1-T))
BU = BL / (1+ (D/E) *(1-T))
New D / (D+E) =.80
Then D / E= .80 /.20 (4:1)
Then New Levered Beta is
Then BL = .63 *(1+(1-.35)*.80/.20)
BL= .63 * 2.6
BL= 1.64

Re-levering Beta- Example

with 35% Tax Rate

Now, use the new levered Beta to

determine revised Ke and WACC!

Preferred Shares General Features

Shares can have a number of designations common, ordinary, Class A and
preferred
Preferred shares typically occupy a position between the companies creditors
and common shares
They have a prior claim on assets ahead of common shares in a windup or
dissolution of the company
Prefs are usually entitled to a fixed dividend payment out of net earnings
Cumulative Feature - dividends do not have to be paid, but if skipped unpaid
dividends accumulate.
Most are non-voting, unless a certain number of dividends have been missed
(typically 8 quarterly) ; then they have voting privileges
There is no maturity date
Prefs do not have a trust indenture (like debt does). The description of preferreds
is in the companys charter
There are many different features that preferred shares can have, some strengthen
the issuers position and others protect the purchaser

28

Preferred Shares - From an Issuers Perspective

Issuers perspective - Prefs are debt that get treated as equity
from rating agencies and regulators
the dividend can be suspended - unlike debt, where the co. would go into default
dividend is paid out of after tax dollars, same as a regular common share
dividend

Motivation to Issue Preferred Shares - overall two main types of

issuers:
i) Corporations that are regulated a) firms want more equity but regulator says no- ie
company that has rate of return considerations
b) regulator wants firm to have more equity than they wish
ii) Corporations trying to maintain a debt rating (avoid a lower rating), or corporations that do
not want dilution of have control issues

Many features and options - flavour of the times: hard retraction, soft
retraction, redeemable, auction set
Currently Issuers are - approximately 30% Financial Institutions, 50%
utilities, 20 % industrials
29

Preferred Share Features

Most preferreds have a fixed dividend expressed as a % of
par or a stated value

e.g. 8% of par or $2.00 (par is typically $25)

Other Common Features

Convertible the holder can convert the pref into common shares at a
predetermined price (conversion price) for a certain time period. Once the
underlying common reaches that level the prefs price starts to reflect the
common stocks mkt price
Redeemable most convertible prefs are redeemable which gives the issuer
the right to force conversion into the underlying shares, when the market price
of these shares is above the conversion price.
Retractable means the holder can require the company to buy back the
retractable preferred on a specified date(s) and at a predetermined price
(retraction price)

30

Preferred Shares - Investor Perspective

Dividend Tax Credit
Because dividends are paid from a companys after tax earnings the
government gives investors a bit of a tax break (ie pay less tax on
dividends)
Dividend Tax Credit: dividends are taxed at a lower rate
The calculation (which is confusing) consists of grossing up the
amount of dividend by 25%, calculating the federal taxes and
deducting a federal tax credit of 16.667% of dividend received . The
provinces also have their own dividend tax credit for provincial taxes
as a rule of thumb most investors consider preferreds as a debt
alternative and gross up Cdn preferred dividends by a set amount in
order to equate (compare) returns with those of interest bearing
instruments (bonds, GICs)

31

Market Value Weights

An Example
Given:

Market price for common stock = $21.50

Bonds are trading for 95% of face value
In order to calculate market value (MV) weights, you will need
to know the total market value of debt, and common stock (and
preferred stock if the company uses it.)
To calculate total MV you need to know the current price of the
security in each class, as well as the total number of securities
outstanding:
Total Market Capitalization = Price Quantity

Market Value Weights - Example

The following balance sheet date, when combined with market
price data, will allow you to calculate MV weights.
XYZ Company Limited
Balance Sheet
as at January 30, 2xxx
ASSETS
Current Assets
Net Fixed Assets

$147,000
15,000,250

LIABILITIES:
Current Liabilities
8.5% 2020 Mortgage Bonds

$75,250
4,000,000

Common stock (1,000,000 outstanding) 7,155,000

Retained earnings
3,917,000
TOTAL ASSETS
EQUITY

$15,147,250
$15,147,250

TOTAL LIABILITIES AND O.

Face value
of bonds
are
Number
of common
shares
$1,000,
therefore
there
outstanding
is read
frommust
the
be 4,000
bondssheet.
outstanding.
balance

Market Value Weights

An Example Continued

Total MV of Equity = Price per share times number of shares = 1M $21.50 = $21.5M
Total MV of Bonds = Price per bond times number of bonds = $950 4,000 = $3,800,000

Type of
Capital
Bonds
Stock

Market
Total Market
price
Number
Value
$950.00
4,000
$3,800,000
$21.50 1,000,000 $21,500,000
TOTAL=
$25,300,000

Market
Value
Weight
15.02%
84.98%
100.00%

These weights could now be used to calculate WACC.

Bond Value
General Formula

In the example, you didnt have to calculate the bond value because you were
given the fact that it was trading at 95% of par.
In the event that you do, however, simply use this equation

[ 20-12]

( 1 k )n
b
B I
kb

1
F
( 1 kb )n

Where:
I = interest (or coupon ) payments
kb = the bond discount rate (or market rate)
n = the term to maturity
F = Face (or par) value of the bond

Floatation Costs
Issuing or floatation costs are incurred by a firm when it
raises new capital through the sale of securities in the
primary market.
These costs include:
Underwriting discounts paid to the investment dealer
Direct costs associated with the issue including legal and
accounting costs

The result:
Net proceeds on the sale of each security is less than what the
investor invests, and
The component cost of capital > investors required return.

Average Floatation Costs

Average Issuing Costs
Commercial paper
Medium-term notes
Long-term debt
Equity (large)
Equity (small)
Equity (private)

0.125%
1.0%
2.0%
5.0%
5.0% - 10.0%
10.0% and up

Floatation costs for

debt securities is
lowest because debt is
normally privately
placed with large
institutional investors
not requiring
underwriting costs and
because debt is either
issued by high quality
issuers or sits at the
top of the priority of
claims list in the case
of default.

The Component Cost of Debt

The cost of debt is a function of:

The investors required rate of return
The tax-deductibility of interest expense
The floatation costs incurred to issue new debt

WACC Common Calculation

Errors Cost of Debt

Any Ideas ??

WACC Common Calculation Errors

Cost of Debt
Must Use Using Market Value of
Debt (versus trading at Par 100).
Must use (1-T) to get the after tax
cost
Forgetting Floatation Cost

WACC Common Calculation Errors

Cost of Preferred Shares

Any Ideas ??

WACC Common Calculation Errors

Cost of Pref. Shares
Must Use Market Value of Pref Shares
Divide dividend per share by current
market price per pref. share
Forgetting Floatation Cost

WACC Common Calculation Errors

Cost of Common Shares

Any Ideas ??

WACC Common Calculation Errors

Cost of Common Shares
Must Use Market Value of
Common
In CAPM, for Rf, should use
Longer Term Govt Debt (10 +
Years), not short term T-Bill rates.
Forgetting Floatation Cost

WACC -Summary

WACC measures the firms cost of financing today,

based on current capital market conditions.

WACC is the Default Firms Discount Rate.

WACC is used to make capital investment decisions.

Raptor Industries
WACC Problem
Review Solution

Determining Capital Structure

in Practice

47

Leverage in Practice

The tradeoff theory helps explain:

Why firms choose debt levels that are below the
maximum, to avoid the costs of financial distress.
Industry differences in the use of leverage because of
different financial distress costs and the volatility of
cash flows.

16-48

Management of Capital Structure

Needs to be viewed as a dynamic process
Too aggressive can lead to financial distress and
bankruptcy
Excess conservatism can put you at a competitive
disadvantage by having a higher cost of capital, and
may also flag you as a takeover target.
The addition of a reasonable amount of debt to
the capital structure can reduce WACC.
Therefore shareholders receive greater should be
reflected in increase stock price.
All of the return, in excess of its WACC, are gains
that accrue to common shareholders
4949

Capital Structure in Practice

Factors favouring corporate ability and willingness
to issue debt:
Capital Market Conditions: Is this a Good Time to
Issue Equity? Is this a Good Time to Issue Debt?
Profitability (so the firm can use interest tax
shield)
Unencumbered tangible assets to be used as
collateral for secured debt.
Stable business operations over time.
Corporate size larger companies may have
greater market acceptance.
Growth rate of the firm.
50

Primary Factors in Determining

Debt Level (Deutsche Bank 2006)
1.
2.
3.
4.
5.
6.
7.

Effect on Credit Rating (57%)

Ability to Continue Investments (52%)
Tax Shield (32%)
Ability to Continue Dividends (31%)
Market Capacity for our Debt (29%)
Debt Transaction Costs (25%)
Action of Industry Competitors (20%)

51

Limits to Debt

What Factors Limit a Companys

Use of Debt ?

15-52

Limits to Debt
Covenants in Existing Debt Security
re: Maximum Leverage

Covenants in Existing Debt Security

re: Minimum Debt service
High Interest Rates
Ability to Service New Debt from
Forecast Cash Flow
15-53