Weighted Average Cost of Capital

WACC

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WACC
The Capital of a company or organisation is made up of two elements Long Term Debt and Equity To find the WACC we simply weight the cost of each by its proportion in the total

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WACC
The cost of Debt is easy to find out We ask a bank (NB It is the after tax cost of Debt that we need) The cost of Equity, as we have discussed is trickier

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WACC An Example
Company A has 50% of its capital in Equity and 50% in Debt Cost of Debt is 7% Tax rate is 25% Risk Free Rate is 5% Premium on the risk free rate is 4% Company Beta is 1.4575
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WACC - Calculation
Debt {7 (1-.25)}=
5.25 x .5 = 2.63

Equity ERA = RF + (ERM RF)B 5 + (9 - 5)1.4575 =10.83 x .5 = 5.42 WACC 8.05

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WACC
This assumes steady state i.e. same risk, same financing and so on What if we are doing something new? Problems - No history, no Beta - We need a proxy
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WACC - Proxy
When using a proxy we need to be careful
How close is it in Business risk and Experience terms?

How close is it in Financial risk terms?

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WACC Adjusting for Financial Risk

Using a leveraged or geared proxy If we intend to finance our project using different proportions of Debt and Equity to those used by our proxy company we have to adjust the proxy Beta to account for the difference in Financial risk

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WACC Adjusting Proxy Beta

Two equations No 1. To un-lever a levered proxy BJU = . BJ . [ 1 + D (1-TC)] E BJU = un-leveraged beta, BJ = leveraged beta D/E = Debt Equity ratio, TC = Tax rate
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WACC Adjusting Proxy Beta

No 2. To lever an un-levered beta
BJ = BJU [ 1+ D (1-TC)] E

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WACC Adjusting Proxy Beta Example

Proxy company beta = Proxy company tax rate = Proxy company D/E = Our Company tax rate = Our intended D/E = 1.3 25% .3 25% .5

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WACC Adjusting Proxy Beta Example

BJU = 1.3 = 1 + .3(1-25) 1.3 1.225 = 1.061

BJ = 1.061[1+.5(1-.25)]

= 1.4575

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