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Weighted Average Cost of Capital

(Relevant to PBE Paper III – Financial Management)

Simon S P Lee, The Chinese University of Hong Kong

The weighted average cost of capital – common shares, preferred shares,

(WACC) is a common topic in the bonds and any other long-term debt (Most companies do not have
financial management examination. – preferred shares. For simplicity, we
This rate, also called the discount where: only use common shares and bonds
rate, is used in evaluating whether a Re = cost of equity in our illustrations.)
project is feasible or not in the net Rd = cost of debt
present value (NPV) analysis, or E = market value of the firm’s A firm derives its assets by either
in assessing the value of an asset. equity raising debt or equity (or both). There
Previous examinations have revealed D = market value of the firm’s debt are costs associated with raising
that many students fail to understand V = E + D = firm value capital and WACC is an average
how to calculate or understand E/V = percentage of financing that figure used to indicate the cost of
WACC. is equity financing a company’s asset base.
D/V = percentage of financing that
WACC is calculated as follows: is debt In determining WACC, the firm’s
equity value, debt value and hence
WACC = E/V x Re + D/V x Rd x WACC is simply a replica of the basic firm value needs to be derived. This
(1-tax rate) accounting equation: Asset = Debt part is definitely not too difficult. You
+ Equity. WACC focuses on the also need to find the cost of the equity
WACC is the proportional average of items on the right hand side of this and the cost of the debt.
each category of capital inside a firm equation.
Basically there are two approaches we do not use the coupon rate of the (You may need to use a computer or
in finding the cost of equity: the bond as reference. Rather, we use the estimation method to find r.)
dividend growth approach and the yield rate. For example, if a bond has
capital asset pricing model (CAPM) coupon rate of 3% and a market price Since the cost of debt is given on an
approach. of 103, this implies that the actual annual basis, Rd = 2 x 3.9268% =
yield is less than 3%. 7.854%. In calculating WACC, we
Using the dividend approach, use the after-tax cost of debt. (This is
Let me use an example to illustrate. because interest payments are eligible
P = D1 / (Re - g) for tax deductions.) If the interest
On the equity side, a company has 50 rate is 7.854%, taking into account
where million shares with market price of the tax deduction, the actual interest
P0 is the current stock price or price $80 per share. The beta of the stock rate must be lower. Thus the after tax
of the stock in period 0. is 1.15 and market risk premium is cost of debt is 7.854% x (1-15%) =
D1 is the dividend in period 1 9%. The risk-free rate is 5%. 6.6759%.
Re is the cost of equity
g is the dividend growth rate On the debt side, the company has A useful way of checking your
$1 billion outstanding debt (face answer is to remember that, for most
Re = D 1 / P 0 + g value). The current price of the debt companies, the cost of debt (before
is 110 and the coupon rate is 9%: the tax) is usually lower than the cost of
This approach only applies to company pays semi-annual coupons equity. If you calculate Re to be less
dividend-paying stock as we need to with 15 years to maturity. Assume the than Rd, you have probably made a
determine the dividend growth rate. tax rate is 15%. mistake.

The other approach is the CAPM, To find the cost of equity, We have the cost of debt and cost of
which was developed by Sharpe, a equity; now we need to find the firm’s
Nobel Prize winner in economics in Re = 5 + 1.15(9) = 15.35% value. The values are as follows:
Remember the market risk premium Equity market value E = 50 million
Re = Rf + ßex (Rm - Rf ) is Rm-Rf. Since this is given, we need ($80) = $4 billion
not deduct 5% from 9%. Debt market value D = $1 billion
Using CAPM, the risk free rate (Rf ) (1+110%) = $1.1 billion
and market return (Rm) have to be To find cost of debt, we turn to the Firm market value V = E + D = $5.1
found, as does the stock’s beta. There bond pricing equation and find r. billion
are many arguments about how
best to determine the risk free rate, P = C x [1 - 1/(1 + r )t]/r + Weight of E = E/V = $4 /$5.1 =
market return and the beta. However, F x 1/(1 + r )t 0.7843
CAPM is relatively more commonly Weight of D = D/V = $1.1 /$ 5.1
used than the dividend growth model We may assume the face value of = 0.2157
since most stocks do not have a stable individual bond = $1,000. Since
dividend history. C = $45 (remember it’s a semi-
annual payment), t = 30, P = $1,100,
When calculating the cost of debt, F=$1,000, we find that r = 3.9268%.
So, what is the WACC? Students must bear in mind that in order to include a risk cushion in
WACC is affected not only by Re their project evaluation. The logic
WACC = 0.7843(15.35%) + and Rd, but it also varies with capital behind this is simple as the process
0.2157(6.6759%) = 13.48% structure. Since Rd is usually lower of finding WACC involves a large
than Re, then the higher the debt degree of estimation: you need to
This rate is used in the evaluation level, the lower the WACC. This estimate the risk free rate, the beta
of a project NPV or in determining partly explains why firms usually and the market return.
the value of an asset. Why is WACC prefer issuing debt first before they
important? For a project to be feasible, raise more equity. So next time you tackle a WACC
not just profitable, it must generate a question, remember this process. In
return higher than the cost of raising As part of their risk management real life the process is similar, just
debt (Rd) and the cost of raising processes, some companies add a more complicated as a company may
equity (Re). risk factor, say 1.5%, to the WACC have different debts with different
interest rates.