Chapter 13

The Weighted-Average
Cost of Capital and
Book Cover
10e Company Valuation

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2018 by The McGraw-Hill Companies, Inc. All rights reserved
 Topics Covered

13.1 Geothermal’s Cost of Capital

13.2 The Weighted-Average Cost of Capital
(WACC)
13.3 Interpreting the WACC
13.4 Measuring Capital Structure
13.5 Estimating Expected Returns
13.6 Valuing Entire Businesses

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 Cost of Capital (1 of 5)

 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 mix of long-term debt and equity financing

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 Cost of Capital (2 of 5)

Example
Geothermal Inc. has the following structure.
Given that Geothermal pays 8% for debt and 14%
for equity, what is the company cost of capital?

Market value of debt $194 30%

Market value of equity 453 70
Market value of assets $647 100%

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 Cost of Capital (3 of 5)

Example (continued)
Given that Geothermal Inc. pays 8% for debt and
14% for equity, what is the company cost of
capital?

Portfolio return = (.3 × 8%) + (.7 × 14%) = 12.2%

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 Cost of Capital (4 of 5)
Example
Geothermal’s debtholders account for 30% of the
company’s capital structure, but they get a smaller share
of income because their 8% 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 (5 of 5)

Example
Given that Geothermal Inc. pays 8% for debt and
14% for equity, what is the company cost of
capital?

Portfolio return = (.3 × 8%) + (.7 × 14%) = 12.2%

Interest is tax deductible. Given a 21% tax rate, debt only

costs us 6.32% (i.e. 8 % × .79).

WACC = (.3 × 6.32%) + (.7 × 14%) = 11.7%

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 WACC (1 of 9)

 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

Company cost of capital = Weighted average of

debt and equity returns

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 WACC (2 of 9)

  total income
𝑟 assets =
value of investments

  ( 𝐷 × 𝑟 debt ) +( 𝐸 × 𝑟 equity )
𝑟 assets =
𝑉

  𝐷 𝐸
(
𝑟 assets =
𝑉 )(
× 𝑟 debt +
𝑉
× 𝑟 equity )
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 WACC (3 of 9)

 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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 WACC (4 of 9)

IMPORTANT

  𝐷 𝐸 E, D, and V are all

𝑟 assets =𝑟 debt ( )
𝑉
+𝑟 equity
𝑉 ( ) 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 (5 of 9)

 Weighted Average Cost of Capital = WACC

  𝐷 𝐸
W ACC =
𝑉 [
×(1− 𝑇 𝑐 )𝑟 debt +
𝑉
× 𝑟 equity ][ ]

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 WACC (6 of 9)

 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 of the after-tax return
on the debt and the return on the equity

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 WACC (7 of 9)
Weighted Average Cost of Capital with Preferred Stock

 W ACC = 𝐷 ×(1− 𝑇 )𝑟 𝑃 𝐸
[ 𝑉 𝑐 debt + ][
× 𝑟 preferred +
𝑉
× 𝑟 equity
][ 𝑉 ]

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 WACC (8 of 9)

Example
Executive Fruit has issued debt, preferred stock and
common stock. The market value of these securities are
$4 million, $2 million, and $6 million, respectively. The
required returns are 6%, 12%, and 18%, respectively.

Q: Determine the WACC for Executive Fruit, Inc.

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 WACC (9 of 9)

Example (continued)
Step 1
Firm Value = 4 + 2 + 6 = $12 million
Step 2
Required returns are given
Step 3
WACC =  124  (1-.21).06 +  122  .12  +  126  .18 
= .1258 or 12.58%

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 WACC for Selected Firms

Expected Interest Proportion Proportion

return on rate on of equity of debt WACC
Company Beta equity (%) debt (%) (E/V) (D/V) (%)
U.S. Steel 3.01 24.1 5.9 0.68 0.32 17.87
Amazon 1.47 13.3 3.9 0.96 0.04 12.91
Disney 1.39 12.7 3.3 0.89 0.11 11.62
Boeing 1.24 11.7 3.3 0.96 0.04 11.33
Intel 1.07 10.5 3.2 0.88 0.12 9.52
Alphabet (Google) 0.91 9.3 3.0 1.00 0.00 9.34
Pfizer 1.02 10.1 3.2 0.84 0.16 8.91
Union Pacific 0.90 9.3 3.2 0.86 0.14 8.32
ExxonMobil 0.82 8.8 2.9 0.92 0.08 8.25
IBM 0.94 9.6 3.2 0.77 0.23 7.94
Starbucks 0.75 8.2 3.5 0.94 0.06 7.91
Coca-Cola 0.70 7.9 3.1 0.85 0.15 7.07
General Electric 1.06 10.5 3.5 0.55 0.45 6.99
McDonald's 0.68 7.8 3.9 0.82 0.18 6.94
Walmart 0.37 5.6 3.0 0.88 0.12 5.18
Newmont Mining 0.10 3.7 4.0 0.83 0.17 3.63

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 Interpreting WACC (1 of 2)

 The WACC is an appropriate discount rate

only for a project that is a carbon copy of
the firm's existing business
 There are two costs of debt financing
– The explicit cost of debt is the rate of interest
bondholders demand
– The implicit cost is the required increase in
return from equity

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 Interpreting WACC (2 of 2)
  
Issues in Using WACC
– Debt has two costs
1. Return on debt
2. Increased cost of equity demanded due to the
increase in risk
– Betas may change with capital structure

– Corporate taxes complicate the analysis and

may change our decision

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 Measuring Capital Structure (1 of 5)

 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

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 Measuring Capital Structure (2 of 5)

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 (3 of 5)

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 $ 800 100.0%

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 Measuring Capital Structure (4 of 5)

Big Oil Book Value Balance Sheet (mil)

If the long term bonds pay an
Bank debt $ 200 25.0%
8% coupon and mature in 12
LT bonds $ 200 25.0%
years, what is their market
Common stock $ 100 12.5%
value assuming a 9% YTM?
Retained earnings $ 300 37.5%
Total $ 800 100.0%

16 16 16 216
PV   2
 3
 ....  12
1.09 1.09 1.09 1.09
 $185.70

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Measuring Capital Structure (5 of 5)

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%

13 - 24
 Required Rates of Return (1 of 4)

 Bonds
rd = YTM

 Common Stock
re = CAPM
= rf + β(rm - rf)

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 Required Rates of Return (2 of 4)

Example
Big Oil has a beta of .85. The risk free rate is 6%
and the market risk premium is 7%.

Q: Determine the WACC for Big Oil.

re = .06 + .85(.07)  .12

WACC =  .243  (1-.21).09 +  .757  .12 

= .1081 or 10.81%
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 Required Rates of Return (3 of 4)

 Dividend Discount Model Cost of Equity

Perpetuity Growth Model =
Div1
P0 =
re  g
Solve for re :
Div1
re = +g
P0

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 Required Rates of Return (4 of 4)

 Expected Return on Preferred Stock

Price of preferred stock =
Div1
P0 =
rpreferred

Solve for rpreferred :

Div1
rpreferred =
P0

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 FCF and PV

 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
 When valuing a business for purchase, always use
FCF

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 Capital Budgeting (1 of 3)

 Valuing a Business
– The value of a business or project is usually computed
as the discounted value of FCF out to a valuation
horizon (H)
– The valuation horizon is sometimes called the terminal
value and is calculated like a perpetuity

FCF1 FCF2 FCFH PVH

PV    ...  
(1  WACC ) (1  WACC )
1 2
(1  WACC ) H
(1  WACC ) H

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 Capital Budgeting (2 of 3)

 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 (3 of 3)

Example – Deconstruction Company

 396.3 
Horizon value     10, 484
 .0878  .05 

7.1 64.5 77.4 38.6 247.5 10, 484

PV(FCF)      
 1.0878  1.0878  1.0878  1.0878  1.0878  1.0878  5
2 3 4 5

 6,910

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