Weighted Average Cost of Capital (WACC)

John Michael T. Delos Reyes

JTD 2020 CONFIDENTIAL March 2020 1

 WACC: An Overview

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Weighted Average Cost of Capital (WACC)

• Capital is composed of both DEBT and EQUITY.

• To compute for WACC, we must know cost of debt and equity first!
• Cost of equity (Ke) problem 1:
1. Dividends today = PhP1.75 per share
2. Growth rate = 4.5%
3. Price today = PhP19.42 per share
Compute for Ke.
• Cost of equity (Ke) problem 2:
1. Stock beta = 1.5
2. Market returns = 11.57%
3. Risk free rate = 4.25%
Compute for Ke.

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Weighted Average Cost of Capital (WACC)

• Cost of debt (Kd) problem:

1. Par value of 5,000
2. Coupon rate = 12.0%
3. Term = 5 years
4. Bonds are trading at a discount, total value is 4,295.
Compute for Kd.

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Weighted Average Cost of Capital (WACC)

• Preferred shares (and its cost) must also be accounted when computing
WACC!
• Preferred shares have little or no growth at all, unlike common shares.
• The formula for cost of preferred share is relatively similar to Ke, except for
growth.
• Formula = Dividends / Price today
• Based on your reading, how do you treat preferred shares, as part of
equity or debt?

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Weighted Average Cost of Capital (WACC)

• Preferred shares: treated as debt as it is prioritized than equity. If you treat

preferred shares as equity, it goes against the meaning of 'equity' (what is
left), since preferred shares will always get something (in case of
liquidation).

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Weighted Average Cost of Capital (WACC)

• A public company’s beta is technically defined as levered (equity) beta.

• If a company is not traded, meaning its beta, per se, cannot be computed.
How do we compute for cost of equity?

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Weighted Average Cost of Capital (WACC)

• Compute for bottom-up (pure play) beta.

STEPS in computing bottom-up (pure play) beta:

• Choose comparables/peers,
• Get each of the comparables’ levered beta,
• Un-lever each beta accordingly,
• Get its simple average,
• Re-lever it using the company’s D/E structure.

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Weighted Average Cost of Capital (WACC)

JTD 2020 CONFIDENTIAL March 2020 9

Weighted Average Cost of Capital (WACC)

• You are valuing a privately held company. Its target capital structure is
35% Debt, 65% Equity.

• Details about its competitors are as follows:

• Competitor A Levered Beta: 0.89; D/E ratio: 25%
• Competitor B Levered Beta: 1.2; D/E ratio: 45%
• Competitor C Unlevered Beta: 0.7; D/E ratio: 55%
• Tax rate is 35%

• Compute for the company’s bottom-up beta.

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Weighted Average Cost of Capital (WACC)

• How to choose an appropriate comparable?

(1) Same industry;
(2) About same market capitalization;
(3) About same economic conditions;
(4) About same playing field (economic, political, environmental, etc);
(5) Same business model.

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Weighted Average Cost of Capital (WACC)

• Putting it all together: Computation of WACC.

• WACC Formula: [Wd*Kd(1-T)]+[Wps*Kps]+[We*Ke]

• Logic: [Debt weight * after tax cost of debt]

+ [Preferred share weight * cost of preferred shares]
+ [common share weight * cost of equity]

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Weighted Average Cost of Capital (WACC)

• What weights to use?

• (1) Target capital structure;
• (2) Market;
• (3) Book value;
• (4) Par/Face Value

• Flotation costs are also considered. It is adjusted via deducting the costs in
the total PAR value.
• Formula: PAR (1-FC)

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 Questions and Answers

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