WEEK 9

Weighted average Cost of Capital

Learning Objectives

Calculate the weighted Average Cost of Capital

• A firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of
capital across all sources, including common shares, preferred shares, and debt.
• The cost of each type of capital is weighted by its percentage of total capital and
they are added together.
• WACC is used in financial modeling as the discount rate to calculate the net
present value of a business.

What is the WACC Formula?

As shown below, the WACC formula is:
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
An extended version of the WACC formula is shown below, which includes the cost of Preferred
Stock (for companies that have it).

The purpose of WACC is to determine the cost of each part of the company’s capital structure
based on the proportion of equity, debt, and preferred stock it has. Each component has a cost to
the company. The company pays a fixed rate of interest on its debt and a fixed yield on its
preferred stock. Even though a firm does not pay a fixed rate of return on common equity, it
does often pay dividends in the form of cash to equity holders.

The weighted average cost of capital is an integral part of a DCF valuation model and, thus, it is
an important concept to understand for finance professionals, especially for investment banking
and corporate development roles. This article will go through each component of the WACC
calculation.

WACC Part 1 – Cost of Equity

The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) which equates
rates of return to volatility (risk vs reward). Below is the formula for the cost of equity:

Re = Rf + β × (Rm − Rf)

Where:

Rf = the risk-free rate (typically the 10-year U.S. Treasury bond yield) β
= equity beta (levered)
Rm = annual return of the market

The cost of equity is an implied cost or an opportunity cost of capital. It is the rate of return
shareholders require, in theory, in order to compensate them for the risk of investing in the stock.
The Beta is a measure of a stock’s volatility of returns relative to the overall market (such as the
S&P 500). It can be calculated by downloading historical return data from Bloomberg or using
the WACC and BETA functions.

Risk-free Rate

The risk-free rate is the return that can be earned by investing in a risk-free security, e.g., U.S.
Treasury bonds. Typically, the yield of the 10-year U.S. Treasury is used for the risk-free rate.
Equity Risk Premium (ERP)

Equity Risk Premium (ERP) is defined as the extra yield that can be earned over the risk-free rate
by investing in the stock market. One simple way to estimate ERP is to subtract the risk-free
return from the market return. This information will normally be enough for most basic financial
analysis. However, in reality, estimating ERP can be a much more detailed task. Generally,
banks take ERP from a publication called Ibbotson’s.

What is WACC used for?

• The Weighted Average Cost of Capital serves as the discount rate for calculating the Net
Present Value (NPV) of a business.
• It is also used to evaluate investment opportunities, as it is considered to represent the
firm’s opportunity cost. Thus, it is used as a hurdle rate by companies.
• A company will commonly use its WACC as a hurdle rate for evaluating mergers and
acquisitions (M&A), as well as for financial modeling of internal investments.
• If an investment opportunity has a lower Internal Rate of Return (IRR) than its WACC, it
should buy back its own shares or pay out a dividend instead of investing in the project.

EXAMPLE

• The Optimal Capital Structure

What Is Optimal Capital Structure? The optimal capital structure of a firm is the best mix of debt
and equity financing that maximizes a company's market value while minimizing its cost of
capital. In theory, debt financing offers the lowest cost of capital due to its tax deductibility

• Understand and compute the Marginal cost of various sources of capital

The marginal cost of capital is the cost to raise one additional dollar of new capital from
each of these sources.

Components of Cost of Capital Marginal Cost of Debt

The marginal cost of debt is a component of the marginal cost of capital. It is the interest rate that
investors expect, adjusted for taxes. For instance, a business raises a new debt at an interest rate of
7%, and the tax rate is 15%. In this case, the marginal cost of debt would be 0.07*(1-0.15) 5.95%.
Marginal Cost of Equity
It is the expected dividend growth rate plus the ratio of dividend for next year to the company’s
stock price, adjusted for the cost of stock issuance. For instance, if the stock issuance cost is 10%
of the current stock price of the company.
If the stock price is $30, then the adjusted stock price is $30*(1-0.10) = $27. And, if the expected
dividend growth rate is 5% and the dividend for the next year is $2, the marginal cost of common
stock capital would be ($2/$27)+5% =12.40%.

For instance, a company raises $2 million by issuing preference shares and pays an annual
dividend of $100,000. In this case, the marginal cost of preferred stock capital is
100,000/2000000 = 5%.

Weighted Marginal Cost of Capital

It is the sum of the weighted marginal cost of all forms of capital. Continuing with the above
examples, suppose a company raises 20% via debt, 50% via equity, and 30% via preferred
stocks. In this case, the weighted marginal cost of capital will be (20%*5.95%)+(60%*12.40%)
+(30%*5%) 10.13%.
WEEK 10 & 11
Capital structure and the use of
leverage: Learning Objectives a.
Leverage

There are two main types of leverage: financial and operating.

• To increase financial leverage, a firm may borrow capital through issuing fixed-
income securities or by borrowing money directly from a lender.
• Operating leverage can also be used to magnify cash flows and returns, and can be
attained through increasing revenues or profit margins. Both methods are
accompanied by risk, such as insolvency, but can be very beneficial to a business.

i. financial leverage
Financial leverage is the use of borrowed money (debt) to finance the purchase of assets
with the expectation that the income or capital gain from the new asset will exceed the cost
of borrowing.

How Financial Leverage Works

When purchasing assets, three options are available to the company for financing:

o using equity,
o debt, and o
leases.

Apart from equity, the rest of the options incur fixed costs that are lower than the income that the
company expects to earn from the asset. In this case, we assume that the company uses debt to
finance asset acquisition.

Example 1

Bob and Jim are both looking to purchase the same house that costs $ 500,000. Bob plans to
make a 10% down payment and take a Ksh450,000 mortgage for the rest of the payment
(mortgage cost is 5% annually). Jim wants to purchase the house for $500,000 cash today. Who
will realize a higher return on investment if they sell the house for $550,000 a year from today?
Although Jim makes a higher profit, Bob sees a much higher return on investment because he
made $27,500 profit with an investment of only $50,000 (while Jim made $50,000 profit with a
$500,000 investment).

Example 2

Using the same example above, Bob and Jim realize they can only sell the house for $400,000
after a year. Who will see a greater loss on their investment?

Now that the value of the house decreased, Bob will see a much higher percentage loss on his
investment (-245%), and a higher absolute dollar amount loss because of the cost of
financing. In this instance, leverage has resulted in an increased loss.

i. Discuss the alternative measures of financial leverage

How Financial Leverage is Measured

Debt-to-Equity Ratio

o The debt-to-equity ratio is used to determine the amount of financial leverage of an

entity, and it shows the proportion of debt to the company’s equity.
o It helps the company’s management, lenders, shareholders, and other stakeholders
understand the level of risk in the company’s capital structure. o It shows the likelihood
of the borrowing entity facing difficulties in meeting its debt obligations or if its levels of
leverage are at healthy levels.
o The debt-to-equity ratio is calculated as follows:
 o Total debt, in this case, refers to the company’s current liabilities (debts that the
company intends to pay within one year or less) and long-term liabilities (debts with a
maturity of more than one year).
o Equity refers to the shareholder’s equity (the amount that shareholders have invested in
the company) plus the amount of retained earnings (the amount that the company retained
from its profits).

Financial Leverage Ratio

o The financial leverage ratio is an indicator of how much debt a company is using to
finance its assets.
o A high ratio means the firm is highly levered (using a large amount of debt to finance its
assets). A low ratio indicates the opposite.

Operating Leverage

o Operating leverage is defined as the ratio of fixed costs to variable costs incurred by a
company in a specific period. o If the fixed costs exceed the amount of variable costs, a
company is considered to have high operating leverage.
o High operating leverage is common in capital-intensive firms such as manufacturing
firms since they require a huge number of machines to manufacture their products.

Regardless of whether the company makes sales or not, the company needs to pay fixed
costs such as depreciation on equipment, overhead on manufacturing plants, and
maintenance costs.

The operating leverage formula measures the proportion of fixed costs per unit of variable or
total cost. When comparing different companies, the same formula should be used.

Example

Company A and company B both manufacture soda in glass bottles. Company A

produced 30,000 bottles, which cost them $2 each. Company B produced 45,000 bottles
at a price of $2.50 each. Company A pays $20,000 in rent, and company B pays $35,000.
Both companies pay an annual rent, which is their only fixed expense. Compute the
operating leverage of each company using both methods.
 Step 1: Compute the total variable cost

• Company A: $2/bottle * 30,000 bottles = $60,000

• Company B: $2.50/bottle * 45,000 bottles = $112,500

Step 2: Find the fixed costs

In our example, the fixed costs are the rent expenses for each company.

• Company A: $20,000
• Company B: $35,000

Step 3: Compute the total costs

• Company A: Total variable cost + Total fixed cost = $60,000 + $20,000 =

$80,000
• Company B: Total variable cost + Total fixed cost = $112,500 + $35,000 =
$147,500

Step 4: Compute the operating leverages

Method 1:

Operating Leverage = Fixed costs / Variable costs

• Company A: $20,000 / $60,000 = 0.333x  Company B: $35,000 / $112,500 =

0.311x

Method 2:

Operating Leverage = Fixed costs / Total costs

• Company A: $20,000 / $80,000 = 0.250x

• Company B: $35,000 / $147,500 = 0.237x

ii. Understand the risk and return implications of financial leverage

Fixed operating expenses, combined with higher revenues or profit, give a company operating
leverage, which magnifies the upside or downside of its operating profit.
 b. Cost of Capital
• Explain the concept of Cost of Capital

What is Cost of Capital?

• Cost of capital is the minimum rate of return that a business must earn before
generating value.
• Before a business can turn a profit, it must at least generate sufficient income to cover
the cost of the capital it uses to fund its operations. This consists of both the cost of
debt and the cost of equity used for financing a business.
• A company’s cost of capital depends, to a large extent, on the type of financing the
company chooses to rely on – its capital structure.
• The company may rely either solely on equity or solely on debt or use a combination
of the two.

The choice of financing makes the cost of capital a crucial variable for every company, as it will
determine its capital structure.

Companies look for the optimal mix of financing that provides adequate funding and minimizes
the cost of capital.

In addition, investors use the cost of capital as one of the financial metrics they consider in
evaluating companies as potential investments.

The cost of capital figure is also important because it is used as the discount rate for the
company’s free cash flows in the DCF analysis model.
How to Calculate Cost of Capital?

The most common approach to calculating the cost of capital is to use the Weighted Average
Cost of Capital (WACC). Under this method, all sources of financing are included in the
calculation, and each source is given a weight relative to its proportion in the company’s capital
structure.

WACC provides us a formula to calculate the cost of capital:

The cost of debt in WACC is the interest rate that a company pays on its existing debt. The cost
of equity is the expected rate of return for the company’s shareholders.

Cost of Capital and Capital Structure

Cost of capital is an important factor in determining the company’s capital structure.

Determining a company’s optimal capital structure can be a tricky endeavor because both debt
financing and equity financing carry respective advantages and disadvantages.
• Debt is a cheaper source of financing, as compared to equity.

Companies can benefit from their debt instruments by expensing the interest payments
made on existing debt and thereby reducing the company’s taxable income. These
reductions in tax liability are known as tax shields. Tax shields are crucial to companies
because they help to preserve the company’s cash flows and the total value of the
company.

• However, at some point, the cost of issuing additional debt will exceed the cost of issuing
new equity. For a company with a lot of debt, adding new debt will increase its risk of
default and the inability to meet its financial obligations. A higher default risk will
increase the cost of debt, as new lenders will ask for a premium to be paid for the higher
default risk.
• In addition, a high default risk may also drive the cost of equity up because shareholders
will likely expect a premium over and above the rate of return for the company’s debt
instruments for taking on the additional risk associated with equity investing.

• Despite its higher cost (equity investors demand a higher risk premium than lenders),
equity financing is attractive because it does not create a default risk to the company.

• Also, equity financing may offer an easier way to raise a large amount of capital,
especially if the company does not have extensive credit established with lenders.
However, for some companies, equity financing may not be a good option, as it will
reduce the control of current shareholders over the business.

• Be able to calculate the Cost of preference

Preferred vs Common Stock vs Debt

 Preferred stock differs from common equity in several ways. A beneficial distinction is
that preferred shareholders are first in line to receive any dividend payments.
a. First –Bond holder
b. Second-Preferred shareholders
c. Lastly common equity holders.

Because of the nature of preferred stock dividends, it is also sometimes known as a perpetuity.
For this reason, the cost of preferred stock formula mimics the perpetuity formula closely.

The Cost of Preferred Stock Formula:

Rp = D (dividend)/ P0 (price)

For example:

A company has preferred stock that has an annual dividend of $3. If the current
share price is $25, what is the cost of preferred stock?

Rp = D / P0

Rp = 3 / 25 = 12%

• It is the job of a company’s management to analyze the costs of all financing options
and pick the best one.
• Since preferred shareholders are entitled to dividends each year, management must
include this in the price of raising capital with preferred stock.

For investors, the cost of preferred stock, once it has been issued, will vary like any other stock
price. That means it will be subject to supply and demand forces in the market. In theory,
preferred stock may be seen as more valuable than common stock, as it has a greater likelihood
of paying a dividend and offers a greater amount of security if the company folds.

• Be able to calculate the Cost of ordinary shares,

What is Cost of Equity?

Cost of Equity is the rate of return a company pays out to equity investors. A firm uses cost of
equity to assess the relative attractiveness of investments, including both internal projects and
external acquisition opportunities. Companies typically use a combination of equity and debt
financing, with equity capital being more expensive.
How to Calculate Cost of Equity

The cost of equity can be calculated by using the CAPM (Capital Asset Pricing Model) or
Dividend Capitalization Model (for companies that pay out dividends).

CAPM (Capital Asset Pricing Model)

CAPM takes into account the riskiness of an investment relative to the market. The model is less
exact due to the estimates made in the calculation (because it uses historical information).

CAPM Formula:

E(Ri) = Rf + βi * [E(Rm) – Rf] Where:

E(Ri) = Expected return on asset i

Rf = Risk-free rate of return βi =

Beta of asset i

E(Rm) = Expected market return

Risk-Free Rate of Return

The return expected from a risk-free investment (if computing the expected return for a US
company, the 10-year Treasury note could be used).

Beta

The measure of systematic risk (the volatility) of the asset relative to the market. Beta can be
found online or calculated by using regression: dividing the covariance of the asset and market’s
returns by the variance of the market.
βi < 1: Asset i is less volatile (relative to the market) βi

= 1: Asset i’s volatility is the same rate as the market βi

> 1: Asset i is more volatile (relative to the market)

Expected Market Return

This value is typically the average return of the market (which the underlying security is a part
of) over a specified period of time (five to ten years is an appropriate range).

Dividend Capitalization Model

The Dividend Capitalization Model only applies to companies that pay dividends, and it also
assumes that the dividends will grow at a constant rate. The model does not account for
investment risk to the extent that CAPM does (since CAPM requires beta).

Dividend Capitalization Formula:

Re = (D1 / P0) + g

Where:

Re = Cost of Equity

D1 = Dividends/share next year

P0 = Current share price g =

Dividend growth rate

• Be able to calculate the Cost of retained earnings

What are Retained Earnings?

• Retained Earnings (RE) are the accumulated portion of a business’s profits that are
not distributed as dividends to shareholders but instead are reserved for reinvestment
back into the business.
• Normally, these funds are used for working capital and fixed asset purchases (capital
expenditures) or allotted for paying off debt obligations.
Retained Earnings are reported on the balance sheet under the shareholder’s equity section at the
end of each accounting period. To calculate RE, the beginning RE balance is added to the net
income or reduced by a net loss and then dividend payouts are subtracted. A summary report
called a statement of retained earnings is also maintained, outlining the changes in RE for a
specific period.

What is the Retained Earnings Formula?

The RE formula is as follows:

RE = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends Where

RE = Retained Earnings

Beginning of Period Retained Earnings

At the end of each accounting period, retained earnings are reported on the balance sheet as the
accumulated income from the prior year (including the current year’s income), minus dividends
paid to shareholders. In the next accounting cycle, the RE ending balance from the previous
accounting period will now become the retained earnings beginning balance.

The RE balance may not always be a positive number, as it may reflect that the current period’s
net loss is greater than that of the RE beginning balance. Alternatively, a large distribution of
dividends that exceed the retained earnings balance can cause it to go negative.

How Net Income Impacts Retained Earnings

Any changes or movement with net income will directly impact the RE balance. Factors such as
an increase or decrease in net income and incurrence of net loss will pave the way to either
business profitability or deficit. The Retained Earnings account can be negative due to large,
cumulative net losses. Naturally, the same items that affect net income affect RE.

Examples of these items include sales revenue, cost of goods sold, depreciation, and other
operating expenses. Non-cash items such as write-downs or impairments and stock-based
compensation also affect the account.
How Dividends Impact Retained Earnings

Distribution of dividends to shareholders can be in the form of cash or stock. Both forms can
reduce the value of RE for the business. Cash dividends represent a cash outflow and are
recorded as reductions in the cash account. These reduce the size of a company’s balance sheet
and asset value as the company no longer owns part of its liquid assets.

Stock dividends, however, do not require a cash outflow. Instead, they reallocate a portion of the
RE to common stock and additional paid-in capital accounts. This allocation does not impact the
overall size of the company’s balance sheet, but it does decrease the value of stocks per share.
End of Period Retained Earnings

At the end of the period, you can calculate your final Retained Earnings balance for the balance
sheet by taking the beginning period, adding any net income or net loss, and subtracting any
dividends.

Example Calculation

In this example, the amount of dividends paid by XYZ is unknown to us, so using the
information from the Balance Sheet and the Income Statement, we can derive it remembering
the formula Beginning RE – Ending RE + Net income (-loss) = Dividends

We already know:
Beginning RE: $77,232

Ending RE: $78,732

Net Income: $5,297

So, $77,232 – $78,732 + $5,297= $3,797

Dividends paid = $3,797

We can confirm this is correct by applying the formula of Beginning RE + Net income (loss) –
dividends = Ending RE

We have then $77,232 + $5,297 – $3,797 = $78,732, which is in fact our figure for Ending
Retained Earnings