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MFIN 6663 Sobey School of Business Saint Mary’s University Greg MacKinnon

Weighted Average Cost of Capital The weighted average cost of capital (WACC) of a firm simply refers to how much, on average, it costs the firm to raise money. That is, it is the average rate that the firm must pay on any new capital that it raises. The importance of the WACC is in its relation to the evaluation of projects. For a scale-enhancing project (see definition below), the WACC is the appropriate discount rate at which to evaluate the project. Definition: A scale-enhancing project is a project that is similar to the firm as a whole. It has a similar level of risk to the existing assets of the firm. The use of the WACC as the discount rate should make intuitive sense. If, for example, the firm must pay an average of 8% on capital that it raises then projects that return less than 8% should be rejected. Projects returning less than the cost of capital will certainly lose money as they will not even cover the payments required to finance the project. This will be reflected in those projects having NPV<0 when 8% is used as a discount rate. The use of the cost of capital as a discount rate is the reason that the costs of financing are never included as cashflows when evaluating a project. For instance, if the firm will have to borrow money in order to finance the project, the cashflows of the loan (receiving the loan, making interest payments and repaying principal) are never considered when estimating the cashflows to an investment. This is because the costs of financing are taken account of in the discount rate, and putting them in as cashflows would mean doublecounting them. When a project is not scale-enhancing, practitioners tend to use ad hoc adjustments to the WACC in order to determine the appropriate discount rate. For instance, one would use a slightly higher discount rate if the project is slightly riskier than the current assets of the firm. These adjustments are based upon “best guesses”, but these guesses are based upon analysis of the risk of the project through things such as sensitivity analysis. The basis of determining WACC is to determine the costs of each of the individual sources of long term financing for the firm, weight those costs by the degree to which the firm uses the different sources, and simply add up the weighted costs. Example: Assume that the firm makes use of only two sources of financing, debt and equity. Let S be the market value of all of the common stock of the firm and D be the market value of all of the debt of the firm. Thus S+D must be the total value of the firm. Let rd be the cost of debt financing for the firm and let rs be the costs for equity financing for the firm (these will be defined later). The WACC for this firm will be:
 S   D  WACC =  r + r  S + D s  S + D d

This equation is the same as saying: WACC = (percent of the firm that is equity) times (cost of equity) plus (percent of the firm that is debt) times (cost of debt) (Note that this example ignored the tax effect of debt.) Conceptually, it is easy to think of the cost of debt. The return to the holder of the debt is the same as the cost to the firm. If the holders of the firm’s debt are earning 5% on their investment, then the debt must be costing the firm 5%. The cost of equity is a little more

The weights used in the WACC for the various sources of capital are based on their market values (although book values are sometimes used because they are easier to obtain). 2) purchase all of the equity and all of the debt of the firm (so that you own the firm free and clear of debt) The risk of the investment would be represented by the weighted average:  D   S  +  β β  D + S  debt  D + S  equity Both methods would give the same result. we have viewed the appropriate discount rate for a project as the opportunity cost of capital. therefore the two measures of risk must be the equal: . βdebt and βequity. There are two ways to “purchase” the firm: 1) purchase all of the assets of the firm (create an identical firm) The risk of this investment would be represented by βasset. although the effect is the same as that of debt. but it means the proof is relatively straight forward). From the opposite viewpoint. the risk of the project is measured by βasset. The general view here is that the financing mix used for a particular project is coincidental. each will have a beta associated with it. which is also the cost of equity capital. It does not make sense to apply different discount rates to identical projects simply because of the choice of financing. Proof that WACC and Opportunity Cost of Capital are the Same Assume that the CAPM holds (this is not necessary to prove that the two things are the same. if the firm has set goals for their capital structure (e. then these goals are used to determine the weights.g. Consider two projects that are identical except that one will be financed through debt and the other through equity. The weights are based upon the capital structure of the firm as a whole. Issuing new equity entails a cost to the current shareholders as they give up a portion of the firm and the right to a portion of the future dividends. a target debt/equity ratio). An expected return of rs is required in order to induce new investors to buy the stock of the firm. Because the bonds and the equity if the firm are both securities. It turns out that the cost of equity financing is simply equal to the expected return of the firm’s stock. We want to use the expected return an asset of equal risk (the opportunity cost of capital) as the discount rate. How can this be reconciled with the use of the WACC as a discount rate? It turns out that the two things are exactly the same. rs is the return that the current shareholders (who own the firm) must give in order to attract new equity capital. Thus. not on the financing used for any particular project. the expected rate of return on an investment of equal risk. This cost is measured by the expected return on the stock.MFIN 6663 Sobey School of Business Saint Mary’s University Greg MacKinnon difficult concept. Up to now. Generally. The view on this is that the firm will reach these goals eventually and therefore they are the appropriate weights to use for determining the cost of long term financing. The risk of the project is the same as the risk of the rest of the assets of the firm (because it is scale-enhancing).

there are four sources of capital: 1) Debt 2) Preferred Stock 3) Common Stock 4) Internally generated funds (retained earnings) 1) Debt: Generally. Hence. This current market rate is measured by the current yield on the bonds of the firm. In this case. the yield of the bonds is: . This is because the yield is the rate the firm would have to pay if it issued new debt now. It is not the coupon rate.000. These reduce the proceeds realized by the firm on a bond issue. Determining the Costs of Financing In order to determine the WACC. (They get less money. it is not the rate that the firm had to pay on old debt that matters but the rate that is prevailing in the market today. These bonds have ten years to maturity and coupon payments are made annually. WACC is the appropriate discount rate.000 on flotation costs. In order to sell all of the bonds. but make the same interest payments). the costs of the individual sources of long term financing must be determined. but the yield that is important.MFIN 6663 Sobey School of Business Saint Mary’s University Greg MacKinnon D   S β βasset =    βdebt +    D + S  D + S  equity Now. the cost of debt is the yield to maturity on the bonds of the firm. the opportunity cost of capital is simply a weighted average of the costs of debt and equity and is equivalent to the WACC. It pays $40. Note that flotation costs will often affect the cost of debt. but the costs of financing are observable. the opportunity cost of capital will be found from: Discount Rate = R f + β asset E[ R M − R f ]  D   S  = Rf +  E R − Rf ]  β E R − Rf ] +  β  D + S  debt [ M  D + S  equity [ M  D   S  = E R − Rf ]  R + β E R − Rf ] +   R +β  D + S  f debt [ M  D + S  f equity [ M ( ) ( ) expected cost of debt=rd expected cost of equity = r s Thus. Example: A firm issues one million in face value of new bonds with a coupon rate of 6%. The reason that the WACC is used instead of directly applying the CAPM with the asset beta is that βasset is unobservable. the firm prices them at $950. This might include things such as the legal fees. administrative fees et cetera of floating a new issue. In reality. That is.

30% Note that interest payments on debt are tax deductible for corporations. Thus.3%(1-0. the effect of the flotation costs are spread out over a longer period (even though they are. In this case. b) Gordon Dividend Growth Model: . That is.34) = 4. of course. the price of the preferred stock net of any flotation costs that would have to be incurred in order to issue new shares. if the effective corporate tax rate on the firm is 34%. 2) Preferred Stock: Preferred stock is like a cross between debt and equity as it is equity that requires a fixed dividend payment. it is really only the after -tax cost of debt that is of concern. Let: dp= fixed annual preferred dividend. then the after tax cost of debt is: 7. Pp=price of preferred rp=cost of preferred equity rp = dp Pp Note that it is actually the net issuing price that should be used in this equation. actually paid up front). the less the effect of flotation costs. 3) Common Stock: There are two main methods used to calculate a cost of equity capital for common stock: a) Capital Asset Pricing Model b) Gordon Dividend Growth Model a) The use of the CAPM simply involves estimating the expected return on the firm’s common stock through CAPM and using that estimate as the cost of common equity capital.70% But. the actual debt to the firm is y*: 910000 = ∑(1 + y*) i =1 60000 i + 1060000 (1 + y*)10 y* = 7.818% Note: The greater the number of years to maturity of the bonds in question. The cost of preferred equity is simply defined as the dividend yield on the stock.MFIN 6663 Sobey School of Business Saint Mary’s University Greg MacKinnon 950000 = ∑(1 + y) i =1 9 9 60000 i + 1060000 (1 + y )10 y = 6. The intuitive reason for this is that with longer lived debt.

This rate would be the “yield” of the stock. is the retention ratio. but will retain some for reinvestment in the firm.MFIN 6663 Sobey School of Business Saint Mary’s University Greg MacKinnon The Gordon Dividend Growth Model is based upon the price of a stock being the discounted value of all the future dividends: P0 = ∑(1 + r ) t =1 ∞ dt t If we know all of the future dividends then we can solve for the discount rate in the above equation. Another way of saying the same thing is that new investors require this return to induce them to invest in the firm’s shares. This number. given constant dividends. b. Let Et be the earnings per share in year t (total firm profit divided by the number of shares). The rate that one solves for in the above equation is the cost of equity (r s) in the Gordon Model. Let R be the return generated on the re-invested earnings. This rate (the IRR of the stock) would be analogous to the yield on a bond. The idea is that the firm retains some earnings and re-invests them in the company so that future earnings are higher. the following should make clear that perpetually constant dividends implies that all profits of the firm are paid out as dividends (which is not a very common real world phenomenon). how does one estimate this rate given that one cannot know all future dividends? Consider the case where dividends are constant forever: P0 = = = ∑(1 + r ) t =1 ∞ ∞ dt d t ∑(1 + r ) t =1 t d rs ∴ rs = d P0 Thus. b. the cost of equity is simply the current dividend yield on the stock (the cost of preferred equity can thus be seen as an application of this approach). Most firms will pay some of Et out as dividends. . However. it the expected return that is required in order to make the present value of the future dividends equal to the current price. Assume that the firm retains a constant percentage of Et each period. In other words. The question is.

g. However. earnings per share is a perpetually increasing series that is growing at the rate bR each period. Let g=bR be the growth rate. Thus: d 1 = (1 − b)E1 = d1 (1 + g)   d t = (1 − b)E1 (1 + g) t −1 = d1 (1 + g) t −1 d 2 = (1 − b)E1 (1 + g) Therefore. it can be seen that g represents the growth rate in earnings per share and in dividends. The first term in the equation is the current dividend yield on the stock. Now. There are two usual methods for this: . (1-b) of earnings must be paid out as dividends. This can easily be calculated. set the present value of future dividends equal to the current stock price and solve for rs: P0 = P0 = rs = ∑ t =1 ∞ d 1 (1 + g) t −1 (1 + rs ) t d1 rs − g d1 +g P0 This is the cost of equity capital by the Gordon Dividend Growth Model. must be estimated. the growth rate.E1 = E1 E 2 = E1 + RbE1 = E1 (1 + bR ) E 3 = E 2 + RbE 2 = E1 (1 + bR ) + RbE1 (1 + bR ) = E1 (1 + bR ) 2   E t = E1 (1 + bR ) t −1 MFIN 6663 Sobey School of Business Saint Mary’s University Greg MacKinnon Thus. G is determined by how much the firm re-invests in itself and the rate of return on those investments. Since the fraction b of earnings per share is retained each period.

have no effect on the cost of capital. there is no separate term within the WACC calculation that represents internal funds. while there are for new issues of stock. there is a cost to using internally generated funds. Since g=bR.MFIN 6663 Sobey School of Business Saint Mary’s University Greg MacKinnon i) If the firm has a policy regarding the retention rate of earnings then this rate can be used to estimate b. If retained earnings would not be enough to cover the required equity financing. the firm must expect to earn more than shareholders could earn investing the money on their own (given the same level of risk). This would be true except for one thing. internally generated funds are the same as equity. The cost of internal funds is the same as the cost of new equity capital except for flotation costs. equal to the expected return on the outside investment opportunities not taken by shareholders. In other words. The discount rate for all projects is affected because. you now have an estimate of g. or pay the funds out to shareholders as dividends and let shareholders invest the funds themselves outside of the firm? In order for it to be optimal to retain the funds. all projects should be evaluated using the marginal cost of capital. 4) Internally generated funds: In most ways. Therefore. . Management is faced with a choice: should they retain these funds and invest them inside the firm. although an important source of funding for firms. R can be estimated by last period’s Return on Equity figure. the cost of internal funds is equal to the cost of common equity (and can be calculated as in (3) above). in reality. This will tend to happen of the firm has recently gone through a period of very high growth (that cannot be expected to last forever) or if the firm has had decreasing EPS (which cannot be expected to last forever). The return expected by shareholders on an investment of equal risk to their investment in the firm is the expected return on the stock itself. Using internal funds to finance and issuing new stock to finance have (almost) the same cost to current shareholders. the cost of using retained cashflows is actually slightly lower. Thus. It would seem that internal funds. ii) Remember that g is also the growth rate of EPS. Thus. Simply take the percentage increase in EPS over a number of years. for which figures are available. Considering one additional project may raise the discount rate for all projects because the additional project may require a new issue of stock. convert this into a yearly rate and use this as an estimate of the growth rate. Internal cash on hand is (as you know from accounting) part of the equity of the firm. Warning: Basing estimated growth rates on historical data can sometimes lead to conclusions that do not make sense. there is a discontinuity in the WACC. Internal funds are simply cashflows generated by the firm’s operations that have not been paid out as dividends. Since internally generated funds and issues of stock are basically the same. then the WACC will increase because a new stock issue will be needed and this involves flotation costs which are now included in the cost of equity. There are no flotation costs for the use of retained cashflow. or an average of the last few years’. Thus. the cost of equity capital without flotation costs is put into the WACC formula if all of the projects that the firm is considering can have their equity portion financed through retained earnings.