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Lecture 13
The Weighted Average Cost of Capital and
Company Valuation

 Reading
 Brealey, Myers, and Marcus, Chapter 13
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Topics Covered
 Cost of Capital
 Weighted Average Cost of Capital (WACC)
 Measuring Capital Structure
 Calculating Required Rates of Return
 Calculating WACC
 Interpreting WACC
 Valuing Entire Businesses
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Cost of Capital
 Cost of Capital - The return the firm’s investors could expect
to earn if they invested in securities with comparable degrees
of risk.

 Capital Structure - The firm’s mix of long term debt

financing and equity financing.
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Cost of Capital

Example
Geothermal Inc. who produces electricity from geothermal has the
following structure. Given that geothermal pays 8% for debt and 14%
for equity, what is the Company Cost of Capital?

Market Value Debt $194 30%

Market Value Equity $453 70%
Market Value Assets $647 100%
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Cost of Capital
Example
 Geothermal Inc. has the following capital structure.
 22.65 million shares trading at market value $20 each share

 Geothermal’s debtholders account for 30% of the company’s capital structure,

but they get a smaller share of income because their return is guaranteed by the
company.
 Geothermal’s stockholders bear more risk and receive, on average, greater
return.
 Of course, if you buy all the debt and all the equity, you get all the income
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Cost of Capital
 Example - what is the Company Cost of Capital?
 Rate of return on company => rate of return on portfolio which
includes all securities (debt + equity)
 Return to investors => the cost to the company
 Assume you are the debt holder and equity holder of the company at
the same time, what is your portfolio return?

PortfolioReturn = (.3 8%) + (.7 14%) = 12.2%

 12.2% is the company cost of capital

 Without debt: company cost of capital = cost of equity
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Cost of Capital
Example - what is the Company Cost of Capital?

Portfolio Return/Cost = (.3  8%) + (.7 14%) = 12.2%

Interest expense is tax deductible. Given a 35% tax

rate, debt only costs us 5.2% (i.e. 8 % x .65).

WACC = (.3  5.2%) + (.7  14%) = 11.4%

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WACC
 Weighted Average Cost of Capital (WACC)
 The expected rate of return on a portfolio of all the firm’s securities,

adjusted for tax savings due to interest payments.

 Is the minimum acceptable rate of return when the firm expands by

investing in similar risk projects

 Company cost of capital = Weighted average of debt and equity returns.

 Weights depends on relative market value of underlying securities
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WACC
 Without tax rate

rassets = total income

value of investments

(D  rdebt ) +(E  requity )

rassets  V

rassets   VD  rdebt    VE  requity 

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WACC
 With tax rate!!
 Taxes are an important consideration in the company cost of
capital because interest payments are deducted from income
before tax is calculated.

After - tax cost of debt = pretax cost  (1 - tax rate)

= rdebt  (1 - Tc)
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Company Cost of Capital

IMPORTANT
E, D, and V are all 
market values of 
equity, debt, and 
total firm value

V  = D + E
D = market value of debt
E = market value of equity = # shares × price per share

rdebt = YTM on bonds
requity = CAPM = rf + β(rm − rf)
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WACC
With tax:
Weighted Average Cost of Capital = WACC
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WACC
Three Steps to Calculating Cost of Capital
1. Calculate the value of each security as a proportion of the
firm’s market value.
2. Determine the required rate of return on each security.
3. Calculate a weighted average after tax return on the debt and
the return on the equity.
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WACC
 Case of McDonald’s on Jan. 1, 2008
 Outstanding shares: 1,182 million at market price:$52, E = 1,182 x 52 =

61,464 million
 Value of debt from balance sheet: D = $9,543 million

 V = D + E = $71,007 million, tax rate = 35%

 D/V = 0.134, E/V = 0.866

 From CAPM: rE = 13.1%

 Average yield: rD = 5.5%

 What is WACC?

 WACC=
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WACC
 What if we have more than two securities?
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WACC
 Weighted Average Cost of Capital with Preferred Stock
 V=D+E+P
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WACC
Example - Executive Fruit has issued debt, preferred stock and common
stock. The market value of these securities are $4 mil, $2 mil, and $6
mil, respectively. The required returns are 6%, 12%, and 18%,
respectively. Tax rate is 21%.
Q: Determine the WACC for Executive Fruit, Inc.
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WACC
Example - continued
Step 1
Firm Value = 4 + 2 + 6 = $12 mil
Step 2
Required returns are given
Step 3
WACC = ?
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WACC
 How to apply WACC?
 Geothermal Inc. proposes expansion costs $30 million and should

generate perpetual cash flow of $4.5 million per year

Revenue 10 million
- operating expense 3.08
= pretax operating cash flow 6.92
- tax at 35% 2.42
after tax cash flow 4.5

 Should we accept this project?

 WACC = 11.4%

• (8% for debt and 14% for equity, tax rate 35%)
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WACC
 NPV = -30 + 4.5/0.114 = +9.5 million. Accept the project!
 Notice that we do not take out the interest expense (borrowing
cost) in the cash flow calculation.
• Why?
• We use WACC as the discount rate which is the overall return
to all investors. Then the cash flow should be those distributed
to all investors.
 We assume this project has the same capital structure and the
same risk as the company
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WACC for capital budgeting

 Any project offering a return more than 11.4% will have a positive NPV,
assuming that the project has the same risk and financing (capital structure) as
the Geothermal’s business.
 If the revenue is reduced to $8.34 million, then

Revenue 8.34 million

- operating expense 3.08

= pretax operating cash flow 5.26

- tax at 35% 1.84

after tax cash flow 3.42
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WACC for capital budgeting

 Revenue (8.34) – operating expenses (3.08) = pre-tax operating cash
flow (5.26)
 Pre-tax operating cash flow (5.26) – 35% tax rate (1.84) = after-tax cash
flow (3.42)
 return to the whole project = 3.42/30 =11.4%.
 NPV = -30+ 3.42/0.114 = 0
 The project’s cash flows are just sufficient to give debt holders and
shareholders the returns they require.
 8.34 million revenue is the break even point which turn the NPV from
positive to negative
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WACC for capital budgeting

 Let’s verify the cash distribution between debt holders and
stockholders!!
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WACC for capital budgeting

 $30 million investment comes from debt holder $9 million (30%) and
stockholder $21 million (70%)
 Each year debt holders get $0.72 million ($9*8%), stockholders get $2.95
million [($5.26-$0.72)(1-35%)]
pretax operating cash flow 5.26
- Interest payment 0.72
= pretax cash flow 4.54
Tax at 35% 1.59
after tax cash flow to equity holders 2.95

 $2.95/$21 = 14%, exactly the same as the stockholder’s required return

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Measuring Capital Structure

 In order to estimate WACC, we need to estimate capital structure first.
 How? What do we need to know?
 In estimating WACC, do not use the Book Value of securities.

 In estimating WACC, use the Market Value of the securities.

 Book Values often do not represent the true market value of a firm’s
securities, especially equity!!
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Measuring Capital Structure

•Market Value of Bonds

• PV of all coupons and par value
discounted at the current YTM.

•Market Value of Equity

• Market price per share multiplied by
the number of outstanding shares.
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Measuring Capital Structure

 Example: measuring WACC for Big Oil

Big Oil Book Value Balance Sheet (mil)

Bank Debt $ 200 25.0%
LT Bonds $ 200 25.0%
Common Stock $ 100 12.5%
Retained Earnings $ 300 37.5%
Total $ 800 100%

• the long term bonds pay an 8% coupon and mature in 12 years

• Common stock: 100 million shares, par value $1, market price $12
• Tax rate: 35%
• What is the capital structure?
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Measuring Capital Structure

•If the long term bonds pay an 8% coupon and mature in 12

years, what is their market value?
• assuming a 9% YTM and annual payment bond
•Coupon payment: 200 million x 8% = 16 million
•PV=?
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Measuring Capital Structure

 Common stock (100 million shares, par value $1, market value $12)
 Book value of stock = $400 million ($100 + $300)
 Market value of stock = $1,200 million (100 mm x $12)

Big Oil Book Value Balance Sheet (mil)

Bank Debt $ 200 25.0%
LT Bonds $ 200 25.0%
Common Stock $ 100 12.5%
Retained Earnings $ 300 37.5%
Total $ 800 100%
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Measuring Capital Structure

Big Oil MARKET Value Balance Sheet (mil)

Bank Debt (mil) $ 200.0 12.6%
LT Bonds $ 185.7 11.7%
Total Debt $ 385.7 24.3%
Common Stock $ 1,200.0 75.7%
Total $ 1,585.7 100.0%

 We know the weights, now what is the next step?

 Required rate of return?
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Required Rates of Return

 Bonds
 rd: Coupon rate? Or YTM?

rd = YTM

 Common Stock
 re= ?
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Required Rates of Return

 Common Stock
 CAPM
 Dividend discount model
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Required Rates of Return

 CAPM

r e = r f +  (r m - r f )
 From historical data
 Beta for this company = 0.85

 Risk free rate = 6%

 Market risk premium = 7%

 Cost of equity=?

• re = 6% + 0.85 x 7% = 12%
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Measuring WACC for Big Oil

security capital required rate of
amount
type structure return
Debt D=$385.7 D/V=.243 r debt = 9%
Equity E=$1,200 E/V=.757 r equity = 12%
Total V=$1,585.7

 WACC=
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Required Rates of Return

 Dividend Discount Model
 Cost of Equity

 Perpetuity Constant Growth Model: P0 =

D iv 1
P0 =
re - g

 solve for re

 For companies with fairly stable growth patterns!!

 Such as utility firms
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Required Rates of Return

 Expected Return on Preferred Stock
 Price of Preferred Stock =

Div 1
P0 =
rpreferred

 solve for rpreferred

Div1
rpreferred =
P0
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WACC for Selected Firms

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WACC for Selected Firms

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Interpreting WACC
 The WACC is an appropriate discount rate only for a project that is a
carbon copy of the firm's existing business.
 Judgmental adjustments can be made for more risky or less risky
ventures.
 Could we lower WACC by increasing borrowing?
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Will changing capital structure affect expected returns?

 Geothermal case
 without tax

Market Value Debt $194 30%

Market Value Equity $453 70%
Market Value Assets $647 100%

WACC = (.3 8%) + (.7 14%) = 12.2%

 If borrow an additional $97 million to buy back $97 million of
common stock, how does the WACC change?
 Wdebt = 45%, Wequity=55%
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Will changing capital structure affect expected returns?

1. If there is no corporate income tax, then increasing debt ratio (eg,

issue debt to repurchase stock) will not change WACC, but will
increase both cost of debt and cost of equity. Further borrowing
increases the required return to equity holders and bondholders
because of higher bankruptcy costs.
2. When corporate income tax rate is not zero, the changing capital
structure may affect WACC.
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Will changing capital structure affect expected returns?

 Debt has two costs.

 1) explicit cost of debt is the expected return demanded by debt holders

 2) implicit cost of debt is the increased expected returns from equity holders

due to the increase in financial risk

 Beta of asset/firm may change with capital structure

 assets = VD x  debt  + VE x  equity 

 Corporate taxes complicate the analysis and may change our decision
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Will changing capital structure affect expected returns?

1. The WACC is the right discount rate for average-risk capital

investments
2. The WACC is the return the company needs to earn after tax in
order to satisfy all its security holders
3. If the firm increases its debt ratio, both the debt and the equity
will become more risky. The debt holders and equity holders
require a higher return to compensate for the increased risk
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Capital Budgeting
 How to evaluate an entire business?
 Free Cash Flows (FCF) should be the theoretical basis for
all PV calculations
 FCF is a more accurate measurement of PV than either Div
or EPS
 The market price does not always reflect the PV of FCF->
overvalue or under value issue!
 When valuing a business for purchase, always use FCF
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Capital Budgeting
 Valuing a Business
 The value of a business or project is usually computed as the discounted
value of Free Cash Flows (FCF) out to a valuation horizon (H).
 The valuation horizon is sometimes called the terminal value and is
calculated like perpetuity.

FCF1 FCF2 FCFH PVH

PV    ...  
(1 WACC)1 (1 WACC)2 (1 WACC)H (1 WACC)H
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FCF
 Free Cash Flows (FCF) should be the theoretical basis for all PV
calculations.
 FCF = Cash flows after the necessary investment expenditures,
available for distribution to all investors (debt holder + equity holder)
 FCF is a more accurate measurement of PV than either Dividend or
EPS.
 The market price does not always reflect the PV of FCF
 FCF = EBIT(1- τ) + Depreciation – changes in net working capital
– changes in fixed asset/expenditure
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Capital Budgeting
 How to evaluate an entire business?
 Example
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Capital Budgeting
 Acquire Concatenator Manufacturing with the following free cash
flows (assume no change in net working capital)

Year 1 2 3 4 5 6
1 Sales 1,189 1,421 1,700 2,020 2,391 2,510
2 Costs 1,070 1,279 1,530 1,818 2,152 2,260
3 EBITDA=1-2 119 142 170 202 239 250
4 Depreciation 45 59 76 99 128 136
5 Profit before tax=3-4 74 83 94 103 111 114
6 tax at 35% 25.9 29.05 32.9 36.05 38.85 39.9
7 Profit after tax=5-6 48.1 53.95 61.1 66.95 72.15 74.1
8 Operating cash flow=4+7 93.1 112.95 137.1 165.95 200.15 210.1
Investment in plant and working
9 166.7 200 240 200 160 130.6
capital (changes!!)
10 Free cash flow ? ? -102.9 -34.05 40.15 79.5
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Capital Budgeting
 Valuing a Business
 The value of a business or project is usually computed as the discounted

value of FCF with the discount rate of WACC.

 Valuation horizon (H) is the period with high growth rate. Growth rate after

the valuation horizon will be lower or zero.

 Here we assume that WACC stays constant over time.

FCF1 FCF 2 FCF H PV H

PV    ...  
(1  r ) 1
(1  r ) 2
(1  r ) H
(1  r ) H
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Capital Budgeting
 Valuing a Business or Project
FCF1 FCF2 FCFH PVH
PV    ...  
(1  WACC)1 (1  WACC)2 (1  WACC) H (1  WACC) H

PV (free cash flows) PV (horizon value)

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Capital Budgeting
 Example - Concatenator Manufacturing
 Assume 60% equity and 40% debt

 re=12% and rd=5%, tax rate=0.35

 WACC

• = 8.5%
 growth rate = 20% in first six years and 5% after six
years, then keeps at 5% forever
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Capital Budgeting
Example - Concatenator Manufacturing
1. FCF=EBIT(1-Tax rate) +Depreciation – changes in PPE and
working capital
2. WACC=8.5%, growth rate = 20% in first six years and 5% after
six years
3. PVH is computed by Gordon model with lower growth rate, what
is PVH?
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Capital Budgeting
Example - Concatenator Manufacturing

Horizon Value  ?

PV(FCF) ?

 Debt =?
 Equity = ?