WACC

Overview
We know how to calculate the firm’s
expected free cash flows
Recall these do not include interest
tax shields, as if project is 100%
equity financed
What discount rate should we use to
calculate value of project?
How do we incorporate tax shields
into calculation?
 Overview
RU is the appropriate rate of return at which to
discount CF of an all equity firm
U=unlevered, sometimes referred to as RA, A=asset
Note that CF of an unlevered firm is same as FCF
WACC is the appropriate rate of return at which to
discount the FCF of any firm
Weighted Average Cost of Capital
For levered firm WACC= RU(1-T*B/V)
For an unlevered (all equity) firm, RU =WACC
If no taxes, RU =WACC
M&M2 gives us a relationship between the equity
return on a firm, and that firm’s unlevered return
RE=RU(1+(1-T)B/E) (if debt risk free)
Equity becomes riskier as debt increases
 Summing Projects
Rf = 2% and E[Rm] = 7%
Consider two all equity firms
A: Value $100M, E[RA]=6% ßA=(6-2)/(7-2)=.8
B: Value $50M, E[RB]=12% ßB=(12-2)/(7-2)=2
What is the expected return on the merged
firm A+B?
Weighted average: VA VB
R AB = RA + RB
V A + VB V A + VB
What is ßAB?
 VA VB  V V 100 50
β AB = Cov RA + RB , RM  = β A A + β B B = .8 +2
 VA + VB VA + VB  VA + VB VA + VB 100 + 50 100 + 50
 Summing Projects
The intuition above carries over to combining debt and
equity to find total return on firm
WACC is the weighted average return on capital, it is the
discount rate by which we should discount total cash flows
coming from the firm
When there are no taxes, it is simply the weighted average
of debt and equity returns:
VE VD
WACC = RE + RD
VE + VD VE + VD
We calculate the value of any asset by discounting its cash
flows by appropriate discount rate
Value of equity is equity cash flows (ie dividends) discounted
by return on equity
Value of debt is debt cash flows (ie coupons) discounted by
return on debt (ie interest rate)
Value of firm is value of total firm payouts (ie
dividends+coupons) disocunted by WACC
 WACC
Debt is not taxed at corporate level but equity is
In the presence of taxes, firm value and discount rate
depends on amount of debt
Tax refunds on debt make the firm appear safer, and
it should be discounted at a lower rate
Recall that FCF (free cash flow or unlevered cash flow)
is defined as total cash flow coming out of the firm if
this firm was all equity
At what rate should we discount the firm’s FCF?
WACC is the rate at which discounted future FCF’s are
equal to firm value
Possible tax shields are taken into account
D E
WACC = rD (1 − T ) + rE
D+E D+E
 Why WACC?
Consider a project (stand-alone) such that one year
hence (year 1):
expected cash-flows: X1
expected value of remaining cash flows: V1
Today (year 0) the projects has:
debt outstanding with market value D0
equity outstanding with market value E0
project’s total value is V0 = D0 +E0
We are looking for the discount rate r such that:

V0 =
(1 − T )X1 + V1
or r=
(1 − T )X1 + V1 − V0
1+ r V0
 Why WACC?
The expected increase in value between years 0 and 1 is:
Expected after - tax cashflow Expected after - tax cashflow Value of future Value of future
to equity holders to debtholders cashflows as of year 1 cashflows as of year 0
6444 474444 8 64748 678 6
474 8
(1 − T )(X1 − rD D0 ) + rD D 0 + V1 − V0
This return is being shared between debt- and equity-holders
Expected after - tax cashflow Annualtax shield Expected Expected
if 100% equity financed of debt payment to debt payment to equity
6444474444 8 64748 64748 64748
(1 − T )X1 + V1 − V0 + TrD D 0 = rD D 0 + rE E 0
Implying that the rate we were looking for is:

r = rD (1 − T )
D0 E0
+ rE = WACC
D0 + E 0 D0 + E 0
 WACC WalMart
Example: Cost of Equity
CAPM: E(r) = rF + β [E(rM) - rF]

β = 0.90

rF = 4.70% (10-year Treasury yield)

E(rM) - rF = 4%

E(r) = 4.70% + 0.90(4%) = 8.30%

 Cost of
Equity Capital: rE
In above example cost of equity
estimate used beta from firm’s own
past returns

What if valuing a new project which

does not have any history?

What if valuing subdivision of a firm

where only aggregate but not
individual betas are available?
 Cost of
Equity Capital: rE
If do not have historical data need to estimate rE from
comparables to the project:
“Pure Plays”, i.e. firms operating only in the project’s industry
The firm undertaking the project (if the project is a pure play)
Problem:
A firm’s capital structure has an impact on rE
Two seemingly identical firms with different capital structure
(leverage) will have different rE
Unless we have comparables with same capital structure, we
need to work on their rE before using it
M&M’s proposition 2 tells us how to adjust a firm’s return
for leverage and taxes
Next lecture:
Unlever comparable firm’s return to calculate return as if there is
no leverage
Relever this hypothetical unlevered return to this firm’s leverage
 WACC Example:
Cost of Debt
Maturity Coupon Price Yield
10/15/23 6¾ 109.66 5.90%

Rating: AA

rB(1-T) = 5.90% (1-0.35) = 3.835%

 Cost of Debt: rB
Where do we get rB?
It is the interest rate lenders would
charge to finance this project at the
given capital structure
Can often look it up
If debt is very risky, this is difficult,
need to estimate default probabilities
Multiple layers of debt? Take average
 Marginal
Tax Rate: T
It’s the marginal tax rate of the firm
undertaking the project (or to be
more precise, of the firm + project)

Indeed, this is the rate that is going

to determine the tax savings
associated with debt.

Marginal as opposed to average tax

rate T
 WACC Example
Equity value:
(# shares)(share price) = S
(4,269.4)(55.69) = $237.8 billion
Debt value (balance sheet): B =
$22.7 bill.
Weights:
V = B+S = 260.5
wB = B/V = 8.7% wS = S/V = 91.3%
 WACC Example
WACC = wB rB(1-T)+wS rS
WACC = 0.09(3.8%) + 0.91(8.3%) ≅ 7.9%

The WACC is WMT’s discount rate for average

risk projects. These projects only create
value (i.e., NPV>0) if they return more
than 7.9%.

What if the risk of a new project is different

from the risk of the firm?
 Leverage
Ratio D/(E+D)
How to get leverage ratio?

Comparables to the project:

“Pure plays” in the same business as the project
Trade-off: Number vs. “quality” of comps

The firm undertaking the project if the

project is very much like the rest of the
firm (i.e., if the firm is a comp for the
project)
 Leverage Ratio
D/(D+E) should be the target capital
structure (in market values) for the
particular project under consideration
Common mistake 1:
Using a priori D/(D+E) of the firm undertaking the
project
Common mistake 2:
Use D/(D+E) of the project’s financing
Example: Using 100% if project is all debt
financed
Caveat: We will assume that the target for
A+B is the result of combining target for A
and target for B. It’s OK most of the time
 Leverage
is not constant

If the project maintains a relatively stable

D/V over time, then WACC is also stable over
time
If not, then WACC should vary over time as
well so you should compute/forecast a
different WACC for each year
In practice, firms tend to use a constant
WACC
So, in practice, WACC method is not great
when capital structure is expected to vary
substantially over time
 WACC:
What could go wrong?

Firm A is considering acquisition of

Firm B

Both are all equity financed (for

simplicity)

Assume no synergies
 WACC:
What could go wrong?
What are the costs of capital for firms A and B?
Assume expected market excess return of 8% and
risk free rate of 2%
Historical Returns:

Month Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Mkt 4.0% -0.2% 1.9% 1.3% -3.1% 0.0% -0.2% 2.5% 2.0% 3.7% 2.4% 1.1%

-
RA 14.8% -2.6% -5.5% 2.7% -9.3% 5.4% -5.3% 9.3% 5.1% 3.7% 0.7% -5.4%

-
RB 7.7% -4.2% 1.3% 11.3% -5.8% 2.9% 3.3% 7.2% 6.4% 5.0% 2.6% 1.7%

βA=.63, βB=1.72
RA=2+.63*8=7.04, RB=2+1.72*8=15.76
 WACC:
What could go wrong?
Assume 100 in 2008 and 2% growth for A and 4% for B
Projected after tax cash flows:

Year 2007 2008 2009 2010 2011 2012 2013 TV

A 0 100 102 104.04 106.13 108.24 110.41 ?

B 0 100 104 108.16 112.49 116.99 121.67 ?

1+ g 1+ g  1+ r
2
What are the terminal values? 1+ +  + ... =
1+ r  1+ r  r−g
A 110.41*1.02*1.0704/(.0704-.02)=2392
B 121.67*1.04*1.1576/(.1576-.04)=1246

What are the stand alone values today? Just discount cash flows:

A 100/1.0704+102/1.07042+… 110.41/1.070426+2392/1.07047=1984.3
B 100/1.1576+104/1.15762+… 116/99/1.15766+1246/1.15767=850.5
 WACC:
What could go wrong?
Suppose firm uses its own discount rate to
value the project
Project value is 1296.1, risky project appears
too good relative to market value
Safe projects appear too bad relative to market
value
After acquisition, firm’s total risk, leverage, and
rate of return may change:
Cov(M,A+B)=Cov(M,A)+Cov(M,B)
The WACC for the conglomerate firm is
(1984.3*7.04+850.5*15.76)/(1984.3+850.5)=
9.66%
 WACC:
What could go wrong?
The value of the firm using its WACC
should be identical to the value of the
stand alone components (assuming
no synergy)

Lets check that this works using two

methods:
Calculate value of stand alone projects in
2008, then use WACC to discount to 2007
Discount all future FCF using WACC
 WACC:
What could go wrong?
Note that the value of the stand alones in
2008 is just the value in 2007 multiplied
by the discount rate:
A 1984.3*1.0704=2124.0
B 850.5*1.1576=984.5

(2124.0+984.5)/1.0966=2834.8=1984.3+
850.5

Indeed, the value of the conglomerate

discounted by the WACC is equal to the
value of the stand alones
 WACC:
What could go wrong?

Year 2007 2008 2009 2010 2011 2012 2013 Terminal

A 0 100 102 104 106.1 108.2 110.4 2392

B 0 100 104 108.2 112.5 117 121.7 1246

A+B 0 200 206 212.2 218.62 225.23 232.08 3638

A+B 200/1.0966+206/1.09662+…
232.08/1.09666+3638/1.09667
=2849.1 ≠ 2834.8 = 1984.3+850.5
What is the problem? Is the WACC incorrect?
 WACC:
What could go wrong?
Note that the relative weights of the projects
within the firm change:
2007: A-share 1984.3/(1984.3+850.5)=70.0%
2008: A-share 2124.0/(2124.0+984.5)=68.3%
As a result, total risk of the firm, and the
WACC change too
This is the same point made earlier about
leverage changes
To get correct results we would need to
recalculate WACC every year
Most “textbook” examples are carefully
rigged to avoid this, but be careful in real
world!
 Summary:
the WACC approach
NPV = Σt UCFt / (1+rWACC)t

UCF = unlevered (total) cash flows

UCF = EBIT(1-T) + depreciation – capex – ∆nwc
rWACC – weighted average cost of capital

r = rD (1 − T )
D0 E0
+ rE = WACC
D0 + E 0 D0 + E 0
Be careful when risk or leverage of various projects is
not the same!