Session 6:

Weighted Average Cost of

Capital

jOANNE r. dIESCA, CPA, mBA

iN cOURTESY OF dR.. eDGEL eARL a. abEAR, cpa
 Outline
• Cost of capital components
– Debt
– Preferred stock
– Common equity
• WACC
• Factors that affect WACC
 COST OF CAPITAL
Why? Business Application
• Key to understanding • Minimum required return
cost of raising $ needed on project
– Risk • Reflects blended costs of
– Financing costs raising capital
– Discount Rate • Relevant “i ”
• Discount rate used to
determine Project’s NPV
or to discount FCFs by
hurdle rate
 Determinants of Intrinsic Value:
The Weighted Average Cost of Capital

Net operating Required

−
profit after investments
taxes in operating capital
Free cash
=
flow
(FCF)

FCF1 FCF2 FCF∞

Value = + + ··· +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted
average
cost of capital
(WACC)
Market interest Firm’s debt/equity
rates
Cost of debt mix

Market risk Cost of Firm’s business

aversion equity risk
What types of long-term capital do firms
use?
• Long-term debt
• Preferred stock
• Common equity
 Capital Components
• Capital components are sources of funding
that come from investors.
• A/P, accruals, and deferred taxes are not
sources of funding that come from
investors, & not included in the calculation
of the cost of capital.
• These items are adjusted for when
calculating project cash flows, not when
calculating the cost of capital.
Before-tax vs. After-tax Capital Costs
• Tax effects associated with financing can be
incorporated either in capital budgeting
cash flows or in cost of capital.
• Most firms incorporate tax effects in the
cost of capital. Therefore, focus on after-
tax costs.
• Only cost of debt is affected.
 Historical (Embedded) Costs vs. New
(Marginal) Costs
• The cost of capital is used primarily to make
decisions which involve raising and
investing new capital. So, focus on
marginal (incremental) costs.
 COST of CAPITAL
Raising $ & its Costs
Debt Equity
• Cost of Borrowing • Internal
– Interest Rate – Retained Earnings

• External
– Common Stock
– Preferred Stock
 Cost of Capital
Raising $ & its Costs
• Debt & Equity

• Cost Return
– Interest paid Interest received
– Dividends paid Dividends received
 EQUITIES
Why? Business Application
• Key to understanding • For Investor:
valuations – Determine value of
asset/business/company
– What is investment
worth today?
– Value of: • For Firm:
• Enterprise – Determine cost of
attracting investors &
• Entity
raising equity capital
• Company/Firm
– Selling ownership stake to
raise $
 What is WACC?
• WACC is the cost of capital for a business that raises
capital from more than one source
• Public companies raise money by selling
– Debt
– Preferred stock
– Common Stock

• WACC reflects the overall mix of securities in the

capital structure
 Debt
Assets
Preferred Stock
Common Stock
 Use of WACC
• WACC is used as a discount rate for evaluating
investment projects
• It is the ‘r’ for NPV calculations
• WACC reflects the risk of the entire company
• WACC is only appropriate to use when the
project is of the same risk as the entire
company
 WACC Formula

D P E
WACC  rD 1  T   rP  rE
V V V

• It is important to understand the inputs

to the WACC formula
 WACC Inputs 1
• D = market value of all debt
• P = market value of preferred stock
• E = market value of common stock

• V = D + P + E = Market value of the entire firm

• D/V, P/V, and E/V are the capital structure

weights – the proportion of the firm financed
by debt, preferred and common stock
 WACC Inputs 2
• rD = cost of debt
• rP = cost of preferred stock
• rE = cost of common stock

• T = marginal corporate tax rate

• We will learn how to estimate all of these

 Cost of Debt (rD)
• Cost of debt is the YTM of the bonds that a
company issues

• If there are more than one type of bonds, then

you must take the weighted average of all the
YTMs

• Weights to be used here are based on market

values of bonds
 Example rD
• A company has the following bonds
outstanding. What is its overall rD?
Coupon Book Market YTM
(%) Value ($m) Value ($m) (%)
6.375 499 521 5.5

7.250 495 543 6.5

7.625 200 226 6.6

 Example rD
• Total market value of bonds:
521 + 543 + 226 = $ _______

• Weights of each bond issue:

521/____ 543/____ 226/____
= ____ =____ =____

• Overall rD =___ x .055 + ___ x .065 + ___ x .066

= _______
 Cost of Preferred (rP)
D
rP 
P0
• Use perpetuity formula:

– D is the annual dividend on preferred stock

– P0 is the latest preferred stock price
 Example rP
• The company has 1 million shares of 8%
preferred stock selling for $120 today. What is
rP?

• rP = _____ / _____ = ______

• Note: 8% preferred means the company pays a

preferred dividend of 8% of its par value which
is always $100
• Note: Flotation costs for preferred, if there’s any,
are significant, so are reflected. Use net price.
 Cost of Common Equity (rE)
• rE can be estimated in one of two ways:

CAPM equation: rE = Rf + [E(Rm) – Rf] x β

• OR

Constant growth formula: rE = D1/P0 + g

 Example rE
• The company has 80 million shares of
common stock outstanding. The per share
book value is $19.10 and the market price is
$62.50. T-bills yield 5%, the market risk
premium is 6%, and the stock’s beta is 1.1

• What is the company’s cost of common equity

according to CAPM?
rE = _______
 Example rE
• The same company just paid a dividend of $5
and analysts estimate that the dividends will
grow at 4% rate forever.

• What is the company’s rE according to

constant growth model?

rE = ________
 Note on rE
• Most companies do not have dividends
growing at a constant rate forever
• It is better to use CAPM equation to estimate
the cost of common equity
• You must use one of the two methods to
estimate rE
• Use caution when using constant growth
method
 Capital Structure Weights
• From previous information compute:

• D/V = ____ / ____ = _____

• P/V = ____ / ____ = _____
• E/V = ____ / ____ = _____

• Assume marginal corporate tax rate (T) of 40%

 Putting it together…
• From previous information, what is the
company’s WACC?

• Answer: WACC = ___________

 Things to remember
• All the inputs to WACC formula must be based
on market values

• Sometimes market value of bond is difficult to

obtain
– In this case you may use book value as an
approximation

• Stock prices are easy to obtain – never use

book values!
 Another Example
• Independence Mining Corporation (IMC) has 7
million shares of common stock outstanding, 1
million shares of 6 percent preferred outstanding,
and 100,000 $1,000 par, 9 percent semiannual
coupon bonds outstanding. The stock sells for $35
per share and has a beta of 1.2, the preferred stock
sells for $60 per share, and the bonds have 15 years
to maturity and sell for 89 percent of par. The market
risk premium is 5.5 percent, T-bills are yielding 6
percent, and the firm’s tax rate is 34 percent.

• Compute IMC’s WACC

 Example continued
• If IMC is evaluating a mining expansion project
that is as risky as the firm’s typical project,
what rate should they use to discount the
project’s cash flows?

• If IMC is thinking of going into shipping

business, can it use the current WACC to
discount the shipping project’s cash flows?
 Caution on using WACC
• If a firm is considering a project that is
substantially different in risk than the firms
current operations

• it CANNOT use the WACC to evaluate this new

project

• It must estimate WACC of other companies

that are in the same line of business as the
new project
 The bottom line in finance
• In any discounting of cash flows

• ALWAYS USE A DISCOUNT RATE (r, in the

denominator) THAT REFLECTS THE RISK OF
THE CASH FLOWS (in the numerator)
 Recap
• We started with TVM

• We always compare cash flows occurring at

different times at the same point in time
– compare apples with apples
• Value of ANY asset is simply the PV of ALL
future cash flows

• For TVM you need cash flows and ‘r’

 Recap
• Cash flows for different assets have different
names:
– For Stocks: cash flows are dividends
– For Bonds: cash flows are interest/principal
– For Projects: cash flows are project cash flows

• Cash flows often need to be estimated

 Recap
• ‘r’ (in general, interest rate or discount rate) has
different names for different assets:
– For Stocks: required rate of return
– For Bonds: yield
– For Projects: cost of capital

• ‘r’ always depends on the riskiness of cash flows

– according to CAPM, risk is measured by beta
– more the risk the higher is ‘r’
 What is finance?
• Understanding risk and return is a major part
of finance

• Most of what we do in finance always comes

back to understanding this simple tradeoff
What factors influence a company’s WACC?

• Uncontrollable factors:
– Market conditions, especially interest rates.
– The market risk premium.
– Tax rates.
• Controllable factors:
– Capital structure policy.
– Dividend policy.
– Investment policy. Firms with riskier projects
generally have higher financing costs.
Financial Risks
 What is RISK?
Risk: situation in which we are not certain about the
outcome in financial world.

“Any event or possibility of an event which can

adversely affect corporate earnings or cash flows
over time. Corporate earnings / cash flows
would influence share holder’s
wealth through valuation of the
corporation.”
 What is RISK?
Risk: variation of potential future returns
from expected returns

Distinguish : risk and uncertainty

• Risk: measureable uncertainty

• Uncertainty: non-measureable risk

 Risk versus Uncertainty
RISK: a state of nature

UNCERTAINTY: a state of human mind

UNCERTAINTY: important element is surprise

We deal with RISK

BUSINESS: decisions made in the presence of risk

 Types of Risk
1. Business risks: related to the underlying nature of business.

Example:
• Uncertainty of future sales
• Uncertainty regarding input costs

2. Financial risks: uncertainty of factors such as:

a. INTEREST RATES
b. FOREX RATES
c. CAPITAL ASSET PRICES / SHARE PRICES
d. COMMODITY PRICES
 Financial Risk
A financial event that can result in
unexpected reduction in a firm’s value or
cash flows / earnings.
 Financial Risk
Unexpected loss for a firm arises as a result of
some adverse change in:
• Market conditions
• Financial condition of a debtor to the firm
• Financial condition of the firm itself
 PRIMARY TYPES OF FINANCIAL RISK

1. Market risk
2. Liquidity risk
3. Interest rate risk
4. Exchange rate risk
5. Commodity price risk
6. Credit risk / counter party risk
 MARKET RISK
Risk of losses as a result of movements in financial
market variables.
Financial market variables: security prices, asset prices,
interest rates, forex rates, etc.
Unfavorable movement in asset prices or security prices
may crucially affect any investment institution.
Valuation of the investment institution
itself may be dependent on the
net value of its assets. Most of
them subject to price risk.
 Price Risk
Different impact on the institution

Depending on its position in the asset or security.

A short position – it has committed to sell, say, security, without actually

holding it.

A long position – it has agreed to buy or has already bought a security / asset
by promising or paying for the same.

Any increase in price or potential increase in price

In short position – adverse impact on the institution

In long position – favorable impact on the insitution

 Volatility Risk
Result not from changes in levels of prices but from the price volatility.

Volatility – degree of unpredictable change in price of a financial

variable over a period of time.

Valuation of option contracts depends on the price volatility of the

underlying asset

Price risk-security prices

Varied causes

Primarily because of changes in investor expectations or attitudes

 Volatility Risk
Basis of such changes: economic, political or
social events.

Intangible events – market psychology, herd

instinct.

Other trigger mechanisms –

threat of war, oil shortage, assassination /
death of a prominent political leader.
 LIQUIDITY RISK
Liquidity risk is the risk involved in selling the asset or
security quickly at a fair price or without making a
substantial price concession.

Sometimes it is referred to as marketability risk.

Liquidity risk is of two types:

1. Funding risk: inability of the firm
to raise funds at normal cost.
2. Asset liquidity risk: lack of depth of trading in the
market for a class of assets or a security
 Funding Risk
It arises due to the necessity of meeting obligations
of the organization on time, especially when
there are sudden and unexpected cash outflows
or drying up of expected cash inflows or both.

Particularly important for banks and other

depository institutions.

A firm exposed to liquidity risk if markets on which

it depends are subject to loss of liquidity.
 Asset Liquidity Risk
When an asset is illiquid, prices become volatile,
sometimes leading to high discounts from par
or from fair price.

A pool of liquid assets acts as a cushion against

fluctuating market liquidity.

Rationale for regulators insisting

financial institutions having a part
of their balance sheet in liquid assets.
 LIQUIDITY RISK
Liquidity risk tends to aggravate other risks.

It can increase credit risk inherent in any credit transaction.

Ex: Suppose that a firm has offsetting cash flows with two different
counter parties on a given day. If the counterparty that owes it
a payment defaults; the firm will
have to raise cash from other sources in
order to make the payment due to the
other counterparty; if it fails to do so;
it will default too.

Certain techniques of asset liability management can be applied to

 LIQUIDITY RISK
To manage liquidity risk,

Firm must diligently monitor potential illiqudity

by closely tracking cash flows

Diversifying sources of funds

Ensuring quick access to liquid assets

 INTEREST RATE RISK
Uncertainty in return by unanticipated
fluctuations in the value of an asset owing to
changes in interest rates.

Particularly important in case of fixed-income

securities.

When interest rates rise, decline in bond prices

 INTEREST RATE RISK
When interest rates fall, increase in bond prices.
Banks and financial institutions function as intermediaries.
Invest in securities and loan assets
At the same time,
Create a set of securities – deposit liabilities
On assets – banks earn a certain interest return
On liabilities – have to pay interest cost
Rate of interest on each is different
Expected to be higher on assets
Difference – net interest income or spread
 INTEREST RATE RISK
Interest rates change
Assets – could be of a relatively longer term
Compared to the time to maturity of deposit liabilities when
interest rates rise
While assets continue to earn a return agreed upon earlier,
depositors ask for a higher rate of interest
Spread reduced
If deposit liabilities have a long term maturity
Assets short term
Interest rates fall
 INTEREST RATE RISK
Firm’s ability to deploy available money at a rate higher than
the rate at which deposits were raised could be impaired.

Decline in profitability

Each firm has to formulate strategies to manage interest rate

risk.

Hedging transactions

Interest rate swap – a derivative

 EXCHANGE RATE RISK
Each nation has its own currency
Normally issued by the central bank of the
respective country.

Firms in different countries now-a-days trade

with each other.

Exports / Imports - goods traded across borders

 EXCHANGE RATE RISK
Selling firm likes to receive payment in a currency that it can
put to use.
Buying firm likes to pay in a currency that it receives when it
sells goods manufactured by it.
Further, governments and firms borrow internationally also.

Multiple currencies come into play.

A market to buy and sell currencies needed.

Foreign exchange market facilities exchange of currencies

 EXCHANGE RATE RISK
With advanced telecommunications, forex market has
become 24 hour market.

One currency can be converted into another currency at the

current rate / spot rate

Hedging transaction

Foreign Currency Forward Contract – a derivative

 EXCHANGE RATE RISK
INFLUENCE ON VALUE OF CURRENCY

1. Demand and supply

Increase in demand for a currency
Exchange rate tends to go up
Increase in supply, exchange rate tends to move
down.
Spurt in demand because of trade flows
or capital flows
Supply is affected by capital flight from a country.
Central banks intervene in forex markets to reduce
demand pressures or supply pressures
 EXCHANGE RATE RISK
INFLUENCE ON VALUE OF CURRENCY

2. Market expectations
Exchange rates driven by expectations
Currency values influenced by
a. Interest rate scenario
b. Exports and imports
c. Borrowing programs of government
d. Corporate borrowing programs –
equity and debt
 COMMODITY PRICE RISK
Changes in commodity prices

May impinge on corporate earnings and value

Ex: When commodity prices / input prices rise corporate
output prices impacted

Earnings / profits may be adversely affected.

Value of corporation may be affected
External risk, not under corporate control

Hedging transaction: Futures Contract – a derivative

 CREDIT RISK / COUNTER PARTY RISK
Businesses enter into numerous transactions,

Ex: Banks and financial institutions.

Financing of clients
Investment activities
Debt and other investment instruments
Banks – forex transactions

In all these transactions, exposed to risk linked to financial

soundness of the other party.
Risk accentuated for a bank when it has completed its part of
the transaction and parted with its own funds.
 CREDIT RISK / COUNTER PARTY RISK
In most financial contracts, counter-party risk is known as
default risk in pure lending transaction.
This risk takes the form of credit risk.

Performance of credit transaction is linked to performance of

the business of borrower.
In turn, this depends on the performance of
economy, industry, management of
specific business / firm.
In case of investment transactions (purchase / sale) counter-
party risk – securities have been delivered, corresponding
funds not received.
 FINANCIAL RISK
Before 1970
Forex rates, interest rates, commodity prices
Occasionally a concern for corporate managers
Fixed exchange rates of the Brettonwood Era.
Long-term interest rates, relatively stable and regulated.
Inflation and commodity price volatilities – quite low.
 FINANCIAL RISK
SINCE 1970s
Break down of Brettonwood system
Floating forex rates
Soaring and volatile oil prices
Spiking and unregulated, interest rates.

New risks – affecting corporate earning,

profits, values.
Increased volatility in forex markets
Economic and financial uncertainty
Spillover to commodity markets
 FINANCIAL RISK
Astounding response of financial community
Mid 70s to Mid-80s
Emerging of new financial instruments and markets
development of derivative instruments and markets.
Trading-not assets but risk itself
These are again found wanting

Recent financial meltdowns.

1. South-east Asian Financial Crisis
2. Financial Crisis – Soviet Union
3. Sub-prime Mortgage Crisis
4. Global Financial Meltdown.
 FINAL REQUIREMENT
Answer the Guide Questions of the following cases:

1. Porter Lumber Company (pp. 449-452)

Anthony, R.N., David, H.F., Merchant, K.A. (2001)
Accounting Text and Cases 10th Edition
2. SKI Equipment Inc. (pp. 570-572)
Brigham, E., Houston, J.F. (2013)
Fundamentals of Financial Management 13 th Edition
3. Aerocomp Corporatation (pp. 484-486)
Block, S.B., Hirt, G.A., Danielsen, B.R., Short, J.D. (2018)
Fundamentals of Financial Management 11 th Edition