Weighted Average Cost of Capital (WACC)

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to
all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital
in which each capital is proportionately weighed.
A firm’s WACC increases as the beta and rate of return on equity increase because an increase in WACC
denotes a decrease in valuation and an increase in risk.
Creditor Hierarchy:

WACC is used in financial modeling as the discount rate to calculate the net present value of a business.

WACC Formula:
WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Where:
E = market value of the firm’s equity (market cap)
D = market value of the firm’s debt
V = total value of capital (equity plus debt)
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on existing debt)
T = tax rate

Problem 1:
Abigayle is financed by 10 million Ph.1 ordinary shares and Ph.8,000,000 8% redeemable
debentures having market values of Ph.1.60 ex div and Ph.90% ex interest respectively. A
dividend of 30p has just been paid and future dividends are expected to grow by 5%. The
debentures are redeemable at par in 5 years time.

Required

If taxation is 30%, calculate the WACC.

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

Re= 30 ( 1.05 ) + 0. 05 = 24.69%

160
E= 10m x 1.6 = P16m
Rd : Internal Rate of Return to company per year

Time Peso DF @ 10% PV DF @ 5% PV

Peso Peso
0 -90 1 -90 1 -90
1-5 8 (1 - 0.30 ) 3.791 21.23 4.329 24.24
5 100 0.621 62.1 0.784 78.4
 -6.67 12.64

IRR = 5% + ( 12.64 / ( 12.64 + 6.67 )) x 5% = 8.3%

D = 8 000 000 x 90% = P 7 200 000

WACC = ( 24.69% x (16 + 7.2 )) + (8.3% x (7.2/(16+7.2)) = 19.6%

Problem 2:
The current date is 20X5.

Book values Market values (Ph.m)

Relevant data
(Ph.m)140 214
Equity (50m shares)
Debt: 10% debentures 20X9 80 90
Per share Annual growth rates

Current dividend 24p 6%

Required

If taxation is 30%, calculate the WACC.

Cost of equity
Dividend valuation model :
= ( ( 24 ( 1.06 ) / 428 ) + 0.06 )
= 0.1194 or 11.94%

Cost of debt
Time 0 1-4 4
Cash flows(after tax) -112.5 7 100
At 10% 1 3.17 0.683
PV -112.5 22.2 68.3 = -22
 At 5% 1 3.546 0.823
PV -112.5 24.8 82.3

Interpolating: 5 + ( -5.2 + 22 ) x 5) = 3.4%

Market value of equity P214m
Market value of debt P90m
WACC= (11.94% x (214/304) + 3.4 x (90/304) ) = 9.4%

Dividend Valuation Model

DVM states that the price of a share of stock is the present value of all its future cash dividends, where
future dividends are discounted at the required rate of return on equity, r.
 Constant Dividend
If these dividends are constant forever, the cost of common stock is derived from the value of
perpetuity (similar to the dividend of preferred stock)- it never matures
Formula:
Ke= dividend/ share price

Problem 3:
A company has Ph.100,000 12% preference shares in issue. The nominal value of these
shares is Ph.1.
The market value today of the shares is Ph.1.25. A dividend has recently been paid.

Required
Calculate the cost of preference share capital.
Cost pre tax = 12 /125 = 9.6%
 Growing Dividend
If dividends are assumed to grow at a constant rate, g, into perpetuity, then the dividend stream
can be discounted to give:

Share price = PV of growing dividends

P0 = D0(1 + g) / (ke - g)
D 0 = current level of dividend
P 0 = current share price
g = estimated growth rate in dividends

If we need to derive ke the formula can be rearranged to:

 ke = [D0 (1+g) / P0 ] + g
Problem 3:
The current price of XYZ stock is $25 per share. If XYZ’s current dividend is $1 per share and
investors’ required rate of return is 10 percent, what is the expected growth rate of dividends for
XYZ, based on the constant growth dividend valuation model?
P0 = D0 (1 + g)  (re – g)
$25 = $1 (1 + g) / (0.10 – g)
$25 (0.10-g) = $1 + g
$2.5 – 25g = $1 + g
$1.5 = 26 g
g = 5.7692%

 Weaknesses of the DVM

Constant Growth
- Po - this can be subject to other short-term influences, such as rumoured takeover bids,
which considerably distort the estimate of the cost of equity.

Estimating Future Growth

-- For simplicity we usually assume no growth or constant growth. These are
unlikely growth patterns. Further, growth estimates based on the past are not always
useful; market trends, economic conditions, inflation, etc. need to be considered.

No relation to earnings
- Earnings do not feature as such in the DVM. However, earnings should be an indicator of
the company's long-term ability to pay dividends and therefore in estimating the rate of
growth of future dividends, the rate of growth of the underlying profits must also be
considered.

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between the expected
return and risk of investing in a security. It shows that the expected return on a security is equal to the risk-
free return plus a risk premium, which is based on the beta of that security.
The Capital Asset Pricing Model (CAPM) gives a way of determining the required return for a given level of
risk.
 Types of Risk
An investor, knowing that a particular investment was risky, could decide to reduce the overall risk
faced, by acquiring a second share with a different risk profile and so obtain a smoother average
return. Reducing the risk in this way is known as diversification.
The risk a shareholder faces is in large part due to the volatility of the company's earnings. This
volatility can occur because of:
1. systematic risk - market wide factors such as the state of the economy. It will affect all
companies in the same way (although to varying degrees).
2. non-systematic risk - company/industry specific factors. It will impact each firm differently,
depending on their circumstances.
However, risk reduction slows and eventually stops altogether once 15-20 carefully selected
investments have been combined.
 3. Modern Portfolio Theory
-Modern Portfolio Theory (MPT) argues that it's possible to design an ideal portfolio that will
provide the investor maximum returns by taking on the optimal amount of risk.
-MPT advocates diversification of securities and asset classes or the benefits of not putting all
your eggs in one basket.
-According to the Modern Portfolio Theory, a portfolio frontier, also known as an efficient
frontier, is a set of portfolios that maximizes expected returns for each level of standard
deviation (risk). A typical portfolio frontier is illustrated below:

The figure below shows the efficient frontier for just two stocks—a high risk/high return technology
stock (like Google) and a low risk/low return consumer stock (like Coca-Cola).

 Formula:

Re = Rf + β × (Rm − Rf)

Where:

Rf = the risk-free rate (typically Government Bonds)

Rm = annual return of the market

β = equity beta (levered)

Commercial databases monitor the sensitivity of firms to a stockmarket downturn by

calculating the average fall in the return on a share each time there is a 1% fall in
the stockmarket as a whole; this is called a beta factor.

Beta factors
 Increasing risk

beta < 1.0 beta = 1.0 beta > 1.0

share < average risk share = average risk share > average risk
Ke < average Ke = average Ke > average

Problem 4:
If there is a market premium for risk of 8%, and the risk-free rate is 4%
(a) what is the required rate of return on a share with an equity beta of 1.6?
(b) what is the cost of equity if the equity beta of a share is 0.8?

a) Ke = 4 + (8 x 1.6) = 16.8%

b) Ke = 4 + (8 x 0.8) = 10.4%

Problem 5:
You analyze the prospects of several companies and come to the following conclusions
about the required return on each:
Stock Required Return
Starbucks 18%
Sears 8%
Microsoft 16%
Limited Brands 12%

You decide to invest $4,000 in Starbucks, $6,000 in Sears, $12,000 in Microsoft, and $3,000 in
Limited Brands. What is the required return on your portfolio?
Total portfolio value = 4,000 + 6,000 + 12,000 + 3,000 = $25,000
rp =(4,000/25,000)18% + (6,000/25,000)8% +(12,000/25,000)16% +(3,000/25,000)12%
rp = 13.92%

Pros:
A. can be used for specific projects
B. looks at systematic risk
C. market based
Cons:
A. data required
B. focus on one period only
C. a way where a return not given is not important
D. there is doubt if investors are diversified