CHAPTER 10

WACC

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 WACC
Weighted Average Cost of Capital

WACC = wdrd(1-T) + wpsrps + wcers (10.10)

Where:

wd = % of debt in capital structure

Weights wps= % of preferred stock in capital structure
wce= % of common equity in capital structure

rd = firm’s cost of debt

Component
costs
rps= firm’s cost of preferred stock
rs= firm’s cost of equity

T = firm’s corporate tax rate

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 NCC’s WACC
Weighted Average Cost of Capital

Component w r
Debt (before tax) 0.30 11.0%
Preferred Stock 0.10 10.3%
Common equity 0.60 14.6%
WACC = wDrD (1- T)+ wPsrPs + wcrs
WACC =0.3(11%)(1-.40)+0.1(10.3%)+0.6(14.6%)
WACC = 11.77%
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Estimating Weights for the
Capital Structure
 Estimate the weights using current
market values rather than current
book values
 If market value of debt is not known:
 Usually reasonable to use the book
values of debt, especially if the debt is
short-term

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Estimating Weights
 Given:
 The stock price is $50
 There are 3 million shares of stock

 $25 million of preferred stock

 $75 million of debt

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Estimating Weights
 Vce = $50 x (3 million) = $150 million
 Vps = $25 million
 Vd = $75 million
 Total value = $150 + $25 + $75 =
$250 million

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Factors that influence a
company’s WACC
 Market conditions
 Interest rates
 The market risk premium
 Tax rates
 Firm’s capital structure
 Firm’s dividend policy
 Firm’s investment policy
 Firms with riskier projects generally have
a higher WACC
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Risk-Adjusted WACC
 The composite WACC reflects the risk
of an average project undertaken by
the firm
 Different divisions/projects may have
different risks
 The division’s or project’s WACC should
be adjusted to reflect the appropriate
risk and capital structure

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 Flotation Costs
 Flotation costs depend on the risk of the
firm and the type of capital being raised
 Flotation costs:
 Highest for common equity
 Most firms issue equity infrequently
 Flotation costs frequently ignored when
calculating WACC

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 Four Mistakes to Avoid
 Current (YTM) vs. historical (Coupon rate) cost of debt
 Mixing current and historical measures to estimate the
market risk premium
 Book weights vs. Market Weights
 Use Target weights
 Use market value of equity
 Book value of debt is a reasonable proxy for market value
 Incorrect cost of capital components
 Only investor provided funding

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