The Cost of Capital or

WACC

Corporate Finance
• The Firm’s Capital Structure
–Capital
–Capital Structure
A Basic Balance Sheet
Weighted Average Cost of Capital
A First Look at the Weighted Average
Cost of Capital

• Weighted Average Cost of Capital

Calculations
– Leverage
• Unlevered
• Levered
A First Look at the Weighted Average
Cost of Capital

• Weighted Average Cost of Capital

Calculations
– The Weighted Average Cost of Capital:
Unlevered Firm
• rWACC = Equity Cost of Capital
A First Look at the Weighted Average
Cost of Capital

• Weighted Average Cost of Capital

Calculations
– The Weighted Average Cost of Capital: Levered
Firm
Example: Calculating the Weights in
the WACC

Problem:
• Suppose Kenai Corp. has debt with a book (face)
value of $10 million, trading at 95% of face value.
• It also has book equity of $10 million, and 1 million
shares of common stock trading at $30 per share.
• What weights should Kenai use in calculating its
WACC?
Example Calculating the
Weights in the WACC

Execute:
• Ten million dollars in debt trading at 95% of face value is
$9.5 million in market value.
• One million shares of stock at $30 per share is $30 million in
market value.
• So, the total value of the firm is $39.5 million. The weights
are:
9.5 ÷ 39.5 = 24.1% for debt and 30 ÷ 39.5 = 75.9% for
equity
Calculating the
Weights in the WACC

Evaluate:
• When calculating its overall cost of capital, Kenai will use a
weighted average of the cost of its debt capital and the cost
of its equity capital, giving a weight of 24.1% to its cost of
debt and a weight of 75.9% to its cost of equity.
Example 2-- Calculating the
Weights in the WACC

Problem:
• Suppose McDonalds Inc. has debt with a
market value of $18 billion outstanding, and
a with a common stock market value of $52
billion, and a book value of $36 billion.
• Which weights should McDonalds use in
calculation of its WACC?
Examplea- Calculating the
Weights in the WACC

Solution:
Plan:
• We know that the weights are the fractions of McDonalds
assets financed with debt and financed with equity.
• We know these weights should be based on market values
because the cost of capital is based on investors’ current
assessment of the value of the firm, not their assessment of
accounting-based book values.
• As a consequence, we can ignore the book value of equity.
Example---Calculating the
Weights in the WACC

Execute:
• Given its $18 billion in debt and $52 billion in equity, the total
value of the firm is $70 billion.

18 ÷ 70 = 25.7% for debt and 52 ÷ 70 = 74.3% for equity

Example-- Calculating the
Weights in the WACC

Problem:
• Suppose 3M Corp. has debt with a book (face)
value of $25 million, trading at 110% of face value.
• It also has book equity of $35 million, and 3 million
shares of common stock trading at $25 per share.
• What weights should 3M use in calculating its
WACC?
Example-- Calculating the
Weights in the WACC

Execute:
• $25 million in debt trading at 110% of face value is $27.5
million in market value.
• Three million ( 30 lakhs) shares of stock at $25 per share
is $75 million in market value.
• So, the total value of the firm is $102.5 million (27.5+ 75).
The weights are:
27.5 ÷ 102.5 = 26.8% for debt and 75 ÷ 102.5 = 73.2%
for equity
 The Firm’s Costs of Debt and Equity
Capital

• Cost of Debt Capital

– Yield to Maturity (YTM) and the Cost of Debt
• The Yield to Maturity is the yield that investors demand to
hold the firm’s debt (new or existing)
• Cost of debt is the interest rate that the firm had to offer
at the time of debt issue.
– Taxes and the Cost of Debt
• Effective Cost of Debt
rD (1  TC)
where TC is the corporate tax rate.
Example- Effective Cost of Debt

Problem:
• By using the yield to maturity on DuPont’s
debt, we found that its pre-tax cost of debt
is 2.81%.
• If DuPont’s tax rate is 35%, what is its
effective cost of debt?
Example-- Effective Cost of Debt

Solution:
Plan:
• We can use following, to calculate DuPont’s effective cost of debt:
rD (1  TC)
rD = 2.81% (pre-tax cost of debt)
TC = 35% (corporate tax rate
Example--Effective Cost of Debt

Execute:
• DuPont’s effective cost of debt is
0.0281 (1 0.35) = 0.01827 = 1.827%.
Example --Effective Cost of Debt

Evaluate:
• For every $1000 it borrows, DuPont pays its bondholders
0.0281($1000) = $28.10 in interest every year.
• Because it can deduct that $28.10 in interest from its
income, every dollar in interest saves DuPont 35 cents in
taxes, so the interest tax deduction reduces the firm’s tax
payment to the government by 0.35($28.10) = $9.83.
• Thus DuPont’s net cost of debt is the $28.10 it pays minus
the $9.83 in reduced tax payments, which is $18.27 per
$1000 or 1.827%.
Example 13.2- Effective Cost of Debt

Problem:
• By using yield to maturity on Gap Inc.’s
debt, we find that its pre-tax cost of debt is
7.13%.
• If Gap Inc.’s tax rate is 40%, what is its
effective cost of debt?
Example - Effective Cost of Debt

Solution:
Plan:
• We can calculate GAP’s effective cost of debt with following
data:
rD =7.13%% (pre-tax cost of debt)
TC =40% (corporate tax rate)
Example 13.2- Effective Cost of Debt

Execute:
• Gap Inc.’s effective cost of debt is
0.0713 (10.40)= .0428 = 4.28%
Example 13.2a Effective Cost of Debt

Evaluate:
• For every $1000 it borrows, Gap Inc. pays its bondholders
0.0713($1000) = $71.30 in interest every year.
• Because it can deduct that $71.30 in interest from its
income, every dollar in interest saves Gap Inc. 40 cents in
taxes, so the interest tax deduction reduces the firm’s tax
payment to the government by 0.40($71.30) =$28.52.
• Thus Gap Inc.’s net cost of debt is the $71.30 it pays minus
the $28.52 in reduced tax payments, which is $42.78 per
$1,000 or 4.28%.
Example 13.2b Effective Cost of Debt

Problem:
• Assume the yield to maturity on Amazon’s
debt that matures in 2 years is 6.5%.
• If Amazon’s tax rate is 39%, what is its
effective cost of debt?
Example 13.2b Effective Cost of Debt

Solution:
Plan:
• We can use following data to calculate Amazon’s effective cost of
debt:
rD = 6.5% (pre-tax cost of debt)
TC = 39% (corporate tax rate
Example 13.2b Effective Cost of Debt

Execute:
• Amazon’s effective cost of debt is
0.065 (1  0.39) = 0.0397 = 3.97%.
Example 13.2b Effective Cost of Debt

Evaluate:
• For every $1,000 it borrows, Amazon pays its bondholders
0.065($1,000) = $65.00 in interest every year.
• Because it can deduct that $25.35 in interest from its income,
every dollar in interest saves Amazon 39 cents in taxes, so
the interest tax deduction reduces the firm’s tax payment to
the government by 0.39($65.00) = $25.35.
• Thus Amazon’s net cost of debt is the $65.00 it pays minus
the $25.35 in reduced tax payments, which is $39.65 per
$1,000 or 3.965%.
 The Firm’s Costs of Debt and Equity
Capital

• Cost of Preferred Stock Capital

Prefered Dividend Div pfd

Cost of Preferred Stock Capital = 
Preferred Stock Price Ppfd

• Assume DuPont’s class A preferred stock has a price of

$66.67 and an annual dividend of $3.50.
• Its cost of preferred stock, therefore, is $3.50 ÷
$66.67 = 5.25%
 Cost of Equity Capital
• Cost of Common Stock Capital
– Capital Asset Pricing Model
1. Estimate the firm’s beta of equity.
2. Determine the risk-free rate, typically by using the
yield on Treasury bills or bonds.
3. Estimate the market risk premium, typically by
comparing historical returns on a market proxy to
contemporaneous risk-free rates
4. Apply the CAPM:
Cost of Equity = Risk-Free Rate + Equity Beta × Market
Risk Premium

E[ Ri ]  rf  i  E[ RMkt ]  rf 
    
Risk Premium for Security i
 Beta- Levered and Unlevered beta

• Beta (β) measures the sensitivity of a

security or portfolio of securities to
systematic risk (i.e. volatility) relative to the
broader securities market.
• Levered and Unlevered Beta are two
different types of beta (β), in which the
distinction is around the inclusion (or
removal) of debt in the capital structure.
• Levered Beta → Inclusive of Capital
Structure (D/E) Effects
• Unlevered Beta → Removed Capital
Structure (D/E) Effects
Levered Beta

• “equity beta”, levered beta is the beta of a

firm inclusive of the effects of the capital
structure.

• Levered Beta
= Unlevered Beta × [1 + (1 – Tax Rate) × (Debt ÷ Equity)]
Unlevered beta or Asset beta

Unlevered beta is often called “asset

beta” because it measures the expected
volatility of the security (and underlying
company) as if the capital structure is
comprised of only equity financing.
As unlevered beta represents pure business
risk, it should NOT incorporate financial risk.
Unlevered Beta
= Levered Beta
[1 + (1 – Tax Rate) * (Debt ÷ Equity)]
The Firm’s Costs of Debt and Equity
Capital

• Cost of Common Stock Capital

– Capital Asset Pricing Model
• Assume the equity beta of DuPont is 1.37, the yield
on ten-year Treasury notes is 3%, and you estimate
the market risk premium to be 6%.
• DuPont’s cost of equity is 3% + 1.37 × 6% = 11.22%

What is Market Return in

above case?
Weighted Average Cost of Capital

• WACC Equation
rwacc = rEE% + rpfd P% + rD(1  TC)D%

– For a company that does not have preferred

stock, the WACC condenses to:

rwacc = rEE% + rD(1  TC)D%

Weighted Average Cost of Capital

– In mid-2013, the market values of DuPont’s

common stock, preferred stock, and debt were
$53,240 million, $221 million, and $14,080
million, respectively.
– Its total value was, therefore, $53,240 million +
$221 million + $14,080 million = $53,240.
– Given the costs of common stock, preferred
stock, and debt we have already computed,
DuPont’s WACC in late mid-2013 was:
Second Look at the Weighted
Average Cost of Capital

• WACC Equation

 53, 240   221   14, 080 

WACC  12.6%    4.08%  67,541   3.66% 1  0.35   67,541 
 67,541     
 10.33%
Computing the WACC

Problem:
• The expected return on Target corporation’s equity is
11.5%, and the firm has a yield to maturity on its debt of
6%.
• Debt accounts for 18% and equity for 82% of Target’s total
market value.
• If its tax rate is 35%, what is this firm’s WACC?
Example 13.4 Computing the WACC

Execute:
Computing the WACC

Evaluate:
• Even though we cannot observe the expected return
of Target’s investments directly, we can use the
expected return on its equity and debt and the
WACC formula to estimate it, adjusting for the tax
advantage of debt.
• Target needs to earn at least a 10.1% return on its
investment in current and new stores to satisfy both
its debt and equity holders.
Computing the WACC

Problem:
• The expected return on Macy’s equity is 10.8%,
and the firm has a yield to maturity on its debt of
8%.
• Debt accounts for 16% and equity for 84% of
Macy’s total market value.
• If its tax rate is 40%, what is this firm’s WACC?
Example 13.4a Computing the WACC

Execute:
rwacc = rEE% + rD(1 TC)D%
= (0.108)(0.84) + (0.08)(1 0.40)(0.16)
= .0984 or 9.84%
Computing the WACC
Exercise 16 – Book chapter 13
Solution
Example 2
A Project in a New Line of Business
• You are working for H.J. Heinz Company evaluating the
possibility of selling a beverage.
• Heinz’ WACC is 6.6%.
• Beverages would be a new line of business for Heinz, however,
so the systematic risk of this business would likely differ from
the systematic risk of Heinz’ current business.
• As a result, the assets of this new business should have a
different cost of capital.
• You need to find the cost of capital for the beverage business.
• Assuming that the risk-free rate is 3.0% and the market risk
premium is 5.4%, how would you estimate the cost of
capital for this type of investment?
Solution:

Plan:
• The first step is to identify a company operating in Heinz’
targeted line of business. Coca-Cola Company is a well-
known marketer of beverages. In fact, that is almost all
Coca-Cola does.
• Thus the cost of capital for Coca-Cola would be a good
estimate of the cost of capital for Heinz’ proposed beverage
business.
• Many Web sites are available that provide company betas,
including http://finance.yahoo.com.
A Project in a New Line of Business

Solution:
• Suppose you visit that site and find that the beta of Coca-
Cola is 0.4.
• With this beta, the risk-free rate, and the market risk
premium, you can use the CAPM to estimate the cost of
equity for Coca-Cola.
• Coca-Cola has a market value debt/assets ratio of .58, and
its cost of debt is 3.8%.
• Its tax rate is 28%.
Execute:
• Using the CAPM, we have:

Coca  Cola 's cost of equity = Risk-free rate + Coca - Cola 's beta×Market Risk Premium
 3%  .4  5.4%  5.8%

• To get Coca-Cola’s WACC, we will use following equation:-

rWACC  rE E %  rD (1  TC )D%
 5.8%(0.42)  3.8%(1  .28)(0.58)  4.02%
A Project in a New Line of Business

Evaluate:
• The correct cost of capital for evaluating a beverage investment
opportunity is 4.02%.
• If we had used the 6.6% cost of capital that is associated with
Heinz’ existing business, we would have mistakenly used too
high of a cost of capital.
• That could lead us to reject the investment, even if it truly had
a positive NPV.