Topic 6

Weighted Average
Cost of Capital
(WACC)
 WACC
What This Topic Is All About
 How to work out the discount rate (r) a firm should use in undertaking a NPV
analysis.

Answer
 Use the average rate of return on the firm’s capital (finance) items, weighted
according to the percentage of the total capital (finance) of the firm each capital
item makes up, i.e. use the weighted average cost of capital (WACC).

Capital Items Used By The Firm

 Equity Items: ordinary shares, preference shares.
 Debt Items: mortgages, overdrafts, debentures/bonds, term loans.
 WACC
What Exactly Is Capital?
 Firm’s stock of funds.

 Represented in balance sheet on the right-hand side as the financial assets of

the firm
Balance Sheet XYZ Co.
Current Assets Liabilities (Debt)

Fixed Assets Proprietorship (Equity)

Real Assets Capital (Finance) Assets

 Capital can be viewed as one of the inputs or factors of production of the firm’s
operations in the same way as salaries and wages, raw materials, rent, fuel and
power
 Just like other inputs capital has a cost and must be paid for.
 WACC
Cost of Capital
 Cost of funds used to finance the activities of the firm.
 Compensation for providers of capital.
 Opportunity cost foregone by providers of capital for investing funds in
the real assets of the firm.
 Rate of return the firm must generate from investment in real assets to
compensate suppliers of capital.
 Cost of debt capital – interest expense.
 Cost of equity capital – dividends.
 WACC
Cost of Capital
 The cost of capital is determined by the use to which it is put:
 Capital is used to finance investment in real assets.
 These real assets in turn generate the cash-flows used to service the
capital.
 The risk of the cash-flows/real assets used to service the capital will be
determined by the nature of the real assets.
 The higher the risk of the cash-flows/real assets, the higher will be the return
required by the suppliers of the capital.

 It is the nature of the investment/real assets that determines the cost of capital.
 WACC
Weighted Average Cost of Capital (WACC)
 As a company draws finance (capital) from several sources, the firm’s cost of
capital is the sum of the weighted average cost of each source of capital, i.e. the
WACC.
 WACC is one cost representative of the cost of all sources of finance, where
each cost is weighted by its relative importance to the total finance of the firm.
 The simple WACC formula (with no taxation) is :

WACC = r = Σ ri wi

where:
r = the weighted average cost of capital
ri = the cost if the ith source of funds
wi= the weighting of the ith source of funds in the firm’s capital structure
 WACC
Cost of Capital Before Tax
Total Revenue
less
Operating costs
equals
Net Operating Income (NOI)
less
Interest expense ( cost of debt )
less
Tax ( cost of government )
equals
Net Income (NI) ( cost of equity (dividends))
 WACC
 WACC assuming two sources of finance (debt & equity) and no tax:

WACC = r = re E/V + rd D/V

where:
re = the cost of equity capital
E/V = the proportion of equity in the capital structure
rd = the cost of debt capital
D/V = the proportion of debt in the capital structure
E = market value of equity
D = market value of debt
V = total market value of the firm (i.e. D + E)
 WACC
Cost of Capital After Tax

 Assuming only two sources of capital (debt & equity):

WACC after-tax = cost of debt + cost of equity

 WACC after tax is the rate of return that the firm needs to earn on its
assets/projects in order to compensate debt and equity holders given the
government has already been compensated.
 WACC
Cost of Capital After-Tax
Interest Payments And Tax
 Interest payments on debt are tax deductible, while dividend payments on equity
are not.
 When calculating the WACC the after-tax cost of debt is (1-t) of the interest
payments (where t = tax rate)
 Therefore, the firm’s assets gets some “help” from the government in covering
the cost of debt which reduces the return that needs to be earned
 WACC
WACC After Tax

 The cost of servicing the debt is rd(D)(1-t) (where D = total debt).

 The cost of servicing equity is re(E) (where E = total equity).

 Therefore, the firm’s assets/capital have to generate a return sufficient to satisfy

both debt and equity holders.

 Let r be the after-tax rate of return the firm can earn on its assets/capital, i.e. r =
WACC.

 WACC = r = re(E/V) + rd(1-t)(D/V)

 WACC
Market Value of The Firm

 In order to calculate the WACC we need to find the market value of the firm.

 A firm is a collection of real assets that generate cash-flows.

How to Value The Firm When Calculating WACC?

 Value the income claims of those having provided the finance to purchase the
real assets of the firm i.e. value the debt and equity of the firm.
 WACC
Balance Sheet XYZ Co.
Real Assets Financial Assets
Used to produce goods & services Claims on cash-flows
– debt & equity

Goods & services are sold and this

generates net cash-inflows

Firm value is given Firm value must equal

by the present value of the present value of the
the net cash-inflow claims upon the
stream generated the net cash-inflow stream

Cash-inflows available for distribution Claims on net cash-inflows -

interest payments and dividends

Assets = Liabilities (debt) + Proprietorship

(equity)
 WACC
Calculating WACC: An Example

 Zoom Ltd has 78.26 million ordinary shares on issue with a book value of
$22.40 per share and a current market price of $58 per share.

 The required rate of return on equity is 11.65%

 The market value of debt is $1.474 billion and the before-tax cost of debt is
7.15%. The company tax rate is 30%.

 What is Zoom’s WACC?

 WACC
 WACC = r = re(E/V) + rd(1-t)(D/V)
 Market value of equity (E): 78.26 million shares x $58 = $4.539billion
 Market Value of debt (D): $1.474billion
 Market value of the firm (V): $4.539b + $1.474b = $6.013billion
 E/V (weighting of equity) = $4.539b/$6.013b = 0.7550 = 75.50%
 D/V (weighting of debt) = $1.474b/$6.013b = 0.2450 = 24.50%
 WACC = r = (0.1165)(0.7550) + (0.715)(1 – 0.30)(0.2450) = 0.1002 = 10.02%
 WACC
The Cost of Ordinary Equity - CAPM
 When calculating the WACC the CAPM is used to estimate the cost of ordinary
shares:

R i  R f  R M - R f  i

Example
 Rf = 6%, Rm = 13%, βi= 1.40.
R i  0.06  0.13 - 0.061.40
R i  0.06  0.071.40
R i  0.06  0.098
R i  0.158  15.8%
 WACC
The Cost of Preference Equity – Dividend Yield
 Preference shares are a perpetuity (i.e. the dividend is fixed), so the cost is:
D
R pref 
P0

 This cost is simply the dividend yield.

Example
 An preference share with an $8 dividend sells for $120 per share today.
 Dividend yield = $8.00/$120 = 0.0667 = 6.67% - this is the cost of the
preference share.
 WACC
Cost of Debt
 The cost of debt, rd, is the interest rate on new borrowings.

 rd is observable:
 yields on currently outstanding debt
 yields on newly-issued similarly-rated bonds

 The historic cost of debt (book value) is not used – we must use the current
cost of debt (i.e. the current interest rate in the market or the yield to
maturity).
 Book values represent historical values and, consequently, fail to recognize
the concept of the cost of capital as an opportunity cost i.e. the price of using
capital as a factor of production.
 WACC
Cost of Debt
Example
 Ishta Co. sold a 20 year, 12% p.a. bond 10 years ago at par of $100. The bond
is currently yielding 14% p.a. What is its current price?
 In finding the current market value of this bond we must use the current market
cost of the bond, which is its yield to maturity, which in this case is the current
interest in the market for the bond of 14% p.a.

1  (1  r )  n  n
bondprice  PMT    facevalue(1  r )
 r 
1  (1.14) 10  10
bondprice  $12   $100(1.14)
 0.14 
bondprice  $125.2161 $100(0.2697)
bondprice  $62.59  $26.97
bondprice  $89.56
 WACC
Cost of Debt - The Effective Interest
Rate
 Remember, when calculating the WACC m
of a firm, for debt items you may need to  NIR 
calculate the effective rate of interest EFF  1   1
(EFF).  m 
 The effective rate of interest will need to 26
be calculated if you are given the  0.12 
nominal annual interest rate (NIR) but EFF  1   1
are told that interest is calculated more
than once per year.
 26 
EFF  1.0046  1
Example 26
 A $300,000 bank loan has just been
taken out by Chen Co. at an interest rate
of 12% p.a. compounded fortnightly (i.e.
EFF  1.1267  1
every two weeks). What is the effective
cost of this bank loan? EFF  0.1267  12.67%
 No. of fortnights in a year = 52/2 = 26 =
no. of compounding periods per year (m)
 WACC
Caveats On Use of The WACC
 When is it appropriate to use the WACC of a company to evaluate one of
the company’s proposed projects?
 The WACC should only be used when:
1. The risk of the project the firm is undertaking is similar in nature and risk to
projects the firm normally takes on; and
2. The way the project is financed is similar to the way in which the firm is
financed. This will be the case if the firm currently has the optimal capital
structure.
 WACC
Calculating WACC
 The 7 Step Process:
1. Identify the relevant components of the Capital Base
2. Calculate the Market Value of each component
3. Determine the Weighting of each component
4. Determine the Before-Tax Cost of each component
5. Determine the After-Tax Cost of each component
6. Calculate the Weighted Cost of each component
7. Sum the weighted costs to obtain the WACC
 WACC
What To Include

 In calculating the WACC of a company you will only have to include the
following six items:
Equity: 1. ordinary shares & 2. preference shares;
Debt: 3. mortgage, 4. overdraft 5. debentures/bonds & 6. term loans
 Items such as trade credit, provisions for bad and doubtful debts,
provisions for taxation & provisions for dividends should be ignored.
 WACC
Example
Following is an extract from the balance sheet of Stratco Ltd. as at 30 June
2010:
 
Equity $'000
Issued And Paid-Up Capital 
75m 50c ordinary shares 37,500
9.5m $1 3.5% preference shares 9,500
 
Reserves and Retained Profits
Retained profits 11,000
Share premium reserve 13,800
General reserve 4,000
71,050
Debt
Mortgage  5,300
Debentures ($1000 each) 6,250
Bank overdraft 14,804
26,354
 WACC
Additional Information
 The current market price of the firm's ordinary shares is $1.00.
 The firm's preference shares are currently selling for 35 cents each.
 The debentures will mature in 2 years. They have a coupon rate of 10% per
annum.
 If the company currently sought long-term finance it would have to pay interest
rates of 12% per annum on debentures. An amount of $5,300,000 is owing on
the mortgage and has 6 years remaining and was taken out at 12% current
rates are 14%
 The firm is currently paying 11% per annum on its bank overdraft loan.
 Interest on debentures. mortgage and the bank overdraft is paid half-yearly.
 The corporate tax rate is 50 cents in the dollar.
 The estimated Beta of the company's ordinary shares is 1.
 The current yield on a 10-year government bond is 12% per annum
 The expected return on the market portfolio is 17% per annum.
 WACC
Equity
1. Ordinary Shares
Market value: 75m shares x $1.00 = $75,000,000.00
Cost: Use CAPM

R i  R f  ( Rm  R f )  i
R i  0.12  (0.17  0.12)1
R i  0.12  (0.05)1
R i  0.12  0.05
R i  0.17  17%
 WACC
Equity
2. Preference Shares
Market value: 9.5m x $0.35 = $3,325,000.00
Cost: Use Dividend Yield
Note: Dividend = 3.5% of par value of $1.00 = $0.035 (i.e. 3.5 cents)
D
DYi 
P0
$0.035
DYi 
$0.35
DYi  0.10  10%
 WACC
Debt
1. Debentures
Market Value: Use Bondprice formula

1  (1  r )  n  n
bondpricei  PMT    facevalue (1  r )
 r 
1  (1.06)  4  4
bondpricei  $50    $1,000(1.06)
 0.06 
bondprice  $503.4651 $1,000(0.7921)
bondprice  $173.26  $792.10
bondprice  $965.36

Total Market Value = 6,250 debentures x $965.36 = $6,033,500.00

 WACC
Debt
2. Mortgage
Step 1: In order to re-value the mortgage we need to work out what the regular
periodic repayment is (i.e. work out what is the PMT). We know that
$5,300,000 is still owing with six years remaining, a 12% p.a. historical interest
rate and a new interest rate of 14% p.a. with interest compounded twice a
year.
We use the PV of an ordinary annuity formula to find the unknown PMT:

1  (1  r )  n 
PV0  PMT  
 r 
1  (1.06) 12 
$5.3m  PMT  
 0.06 
$5.3m  PMT 8.3838
$5.3m
PMT 
8.3838
PMT  $632,171.57

Slide 29
 WACC
Debt
2. Mortgage
Step 2: Having worked out what the regular periodic repayment is and knowing
the current market mortgage interest rate (14%) we can now re-value the
mortgage.
We use the PV of an ordinary annuity formula to find the new PV of the
mortgage:

1  (1  r )  n 
PV0  PMT  
 r 
1  (1.07) 12 
PV0  $632,171.57  
 0.07 
PV0  $632,171.577.9427 
PV0  $5,021,149.13

Slide 30
 WACC
Item Market Value Weight
Ordinary Shares $75,000,000 0.72
Preference Shares $3,325,000 0.032
Mortgage $5,021,149 0.048
Debentures $6,033,500 0.058
Overdraft $14,804,000 0.142
$104,183,649 1.00

Slide 31
 WACC
Effective Cost of Debt
 Since we are given the annual (nominal) interest rates on the debt items and are told that interest on the debt
items is calculated more than once per year, we must work out the effective before-tax cost of the debt items.
We use the effective rate of interest formula (EFF) to do this:
m
 NIR 
EFF  1   1
 m 
 For the Debentures the effective rate is:
2
 0.12 
 1  1.06  1  1.1236  1  0.1236  12.36% p.a.
2
EFF  1  
 2 
 For the Bank Overdraft the effective rate is:
2
 0.11 
EFF  1    1  
1 . 0552
 1  1.1130  1  0.1130  11 .30% p.a.
 2 
 For the Mortgage the effective rate is:
2
 0.14 
EFF  1    1  
1 . 07 2
 1  1.1449  1  0.1449  14.49% p.a.
 2 

Slide 32
 WACC
Cost of Debt After-Tax
 Since the cost of debt (interest expense) is tax deductable, we must work out the cost after tax
of each of the debt items using the formula r d(1 – t), where rd is the effective cost of the debt
item and t is the tax rate.
 Cost of Debentures after-tax = 0.1236(1 – 0.50) = 0.1236(0.50) = 0.0618 = 6.18% p.a.
 Cost of Bank Overdraft after-tax = 0.1130(1 – 0.50) = 0.1130(0.50) = 0.0565 = 5.65% p.a.
 Cost of Mortgage after-tax = 0.1449(1 – 0.50) = 0.1449(0.50) = 0.0725 = 7.25% p.a.

Slide 33
 WACC
Item Market Weight Cost Cost Weighted
Value Before After Cost
Tax Tax

O/Sh 75,000,000 0.72 0.17 0.17 0.1224

P/Sh 3,325,000 0.032 0.10 0.10 0.0032
Mort. 5,021,149 0.048 0.145 0.0725 0.0035
Deb. 6,033,500 0.058 0.1236 0.0618 0.0036
B O/D. 14,804,000 0.142 0.1130 0.0565 0.0080
104,183,649 WACC = 0.1407
= 14.07%

Slide 34