Chapter 13

The Weighted-
Average Cost of
Capital and
Company Valuation

Copyright © 2015 by The McGraw-Hill Companies, Inc. All rights reserved

 Topics Covered

13.1 Geothermal’s Cost of Capital

13.2 Weighted Average Cost of Capital
(WACC)
13.3 Measuring Capital Structure
13.4 Calculating WACC
13.5 Interpreting WACC
13.6 Valuing Entire Businesses

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 Cost of Capital
 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

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

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%

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 Cost of Capital

Example - Geothermal’s debtholders account for 30% of the

company’s capital structure, but they get a smaller share of
income because their 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
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 35% tax rate, debt only

costs us 5.2% (i.e. 8 % × .65).

WACC = (.3 × 5.2%) + (.7 × 14%) = 11.4%

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 WACC

 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

  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
 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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 Company Cost of Capital

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

Weighted Average Cost of Capital = WACC

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

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 WACC

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 after tax return
on the debt and the return on the equity

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 WACC

Weighted Average Cost of Capital with

Preferred Stock

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

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 WACC

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

Q: Determine the WACC for Executive Fruit, Inc.

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 WACC

Example - continued
Step 1
Firm Value = 4 + 2 + 6 = $12 mil
Step 2
Required returns are given
Step 3

WACC =  124  (1 - .35).06 +  122  .12 +  126  .18

= .123 or 12.3%

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 Measuring Capital Structure
 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

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

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

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

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%

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 Required Rates of Return

Bonds
kd = YTM

Common Stock
re = CAPM
= rf + β(rm − rf)

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 WACC

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 - .35).09 +  .757  .12

= .105 or 10.5%
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 Required Rates of Return

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

Expected Return on Preferred Stock

Price of preferred stock =

Div1
P0 =
rpreferred

Solve for rpreferred:

Div1
rpreferred =
P0

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WACC for Selected Firms

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 Interpreting WACC

 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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 WACC
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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 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

 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

 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

Example - Concatenator Manufacturing

 303.8 
Horizon value     8,680
 .085  .05 

 32.8  71.0  85.2  54.8 183.4 8,680

PV(FCF)      
1.085 1.085 2 1.085 3 1.085 4 1.085 5 1.085 5
 5,697.50

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