7064 handouts wacc

8/2/2019 7064 Handouts WACC

1/21

Weighted Average Cost of Capital

Banikanta MishraXIM-Bhubaneswar


2/21

(Weighted Average) Cost ofCapital

A company says that its current WACC is 20%.

What does this 20% Cost of Capital loosely mean?

For every $1 raised by the company now,

it has to pay out

(in form of dividends and interest)

$0.20 - or 20 cents - per year for ever

[Since we are talking about perpetual debt,

we are ignoring the par-value of the bond.]

3/18/2012 2Professor Banikanta Mishra


3/21

Why is WACC Important?

Why is this 20% WACC relevant?

Because this also means that,

the company has to earn

at least 20 cents per $1 (or, 20%).

This is therefore called the hurdle rate.

Regulators call this the fair return.



4/21

How is WACC Computed?

where RE, RD, and RP denote

respective RRRs on Equity, Debt, and Preferred-Stock

and WE, WD, and WP denote

respective weights on these three sources of financing

Two questions arise:

1) Why are we taking R, the Return or RRR, as the Cost of financing?

2) What are the weights Ws - mentioned above?


PPDDEE RWRWRWWACC


5/21

Return as the Cost

1) Why are we taking R, the Return, as the Cost of financing?What is RETURN from the investors perspective

is the COST from the firms perspective

(ignoring flotation or issuance costs)

Note: We should always take the CURRENT or MARGINAL Cost (RRR),

NOT the HISTORICAL Cost (or RRR)

For instance,

if our existing debt was issued two years back at a cost of 10%,

our Cost of Debt is not 10% now

We have to find out what it would cost us

if we issue debt TODAY

Caveat: Moreover, RRR depends NOT on the source of funds, but its use(for instance, RRR of equity raised for investment in a risk-free project is Rf.)



6/21

Use Only Target Weights

2) What are the weights?Ideally, these weights should be firms TARGET WEIGHTS based on market-values

(e.g. a firm may target to have 60% Equity, 30% Debt, and 10% Preferred OR target 2:1 Debt-Equity Ratio )

But if the Target Weights are not available, we can assume the following

where E, D, and P denote, respectively, MARKET VALUES of Debt, Equity, and Preferred,

and, V, as usual, denotes the sum of these market-values (=> V = E + D + P)]

Note: If Market value of Debt and Preferred are not available,

we can take the book-values as surrogates

Caveat: Even when a project is financed with only debt or only equity,

the relevant RRR is still the WACC based on Target Weights,

NOT one based on 100% debt or 100% equity or on weights different from Target


VPWand,

VDW,

VEW PDE


7/21

Which WACC to Use?

should be used to discount actual (or Levered) Operating CF

BUT, if we want to discount the UNLEVERED OCF

= OCF - Interest Tax Shield = OCF (Interest x tc),

we should use

where E/V is the Market-Value-based Target Weight on Equity,and D/V and P/V are defined accordingly

PcDE RV

P)t1(R

V

DR

V

EWACC)adjustedTax(


PPDDEE RWRWRWWACC


8/21

WACC Variations

If Current Liabilities (CL) is an important financing source,

the firm should use the following WACC to discount unlevered CFs

If a firm is is financed with only Debt and Equity,

It should use the following WACC to discount unlevered CFs

This is often taken as the default WACC.


CLPcDE RV

CLR

V

P)t1(R

V

DR

V

EWACC

EcD RV

E)t1(R

V

DWACC


9/21

Firm as a Portfolio of Two Divisions

For a firm with two divisions: X and Y,

where a divisions weight represents

the fraction of firm-value accounted for by the division,

But, getting a divisions value is difficult,

and, therefore, so is its weight

Weight should be based on a stockconcept (like NFA),

and NOT on aflowconcept (like revenue or expense)Correspondingly, the WACC of the company is

where RX is the RRR for Division-X and RYfor Division-YYYXX RWRWWACC


YYXXA ww


10/21

Divisional Cost-of-Capital

3/18/2012 Professor Banikanta Mishra 10

WACC is the appropriate discount-rate to valuea project as risky as the overall firm

BUT, when valuing a project for Division-X,

we should use RX as the discount-rate,

and similarly RY for Division-Y projects,

assuming that a project for a division

is as risky as the division itself(that is, the typical project in the division)

But, how do we find out RX and RY?

Pure Play Approach: Look at similar firms

Subjective Approach: Fudge factor?

Similar means same business, same leverage (?)


11/21

Computing a Firms WACC: Practice


Required Data (Notice Overlaps):

Growth-Rate in Dividends, Earnings, Prices

Most Recent Dividend and Share Price

Historical Return on firms Stock and Market Index

(oreta of Firms Stock)

Current Rate on Treasury (90-day / 1-year / )

Historical Index-Treasury Spread

(that is. RmRffor chosen Index and Treasury)

Coupon-Rate, Amount, Current Price of each Bond issue

Target Debt-Equity Ratio: Market-Value-based

(or Number of Shares Outstanding and Share Price,

Amount or Face Value of Debt for each past issue,

and current Bond Market-Price Quote for each issue)

DDM

CAPM

COD

WEIGHTS

COE


12/21

Cost of Debt


Typically the Cost of Long-term Debt

We know COD = RRR = Rf+ Risk-Premium

But, how do we compute it?

It is the Effective Yield or,for annual coupon, YTMSuppose $1,000,000 Face-Value debt outstanding

Current Quote: 115 ( => Price is $115 per $100 Par)

Time to Maturity: 7 yearsCoupon Rate: 10%, annual payments

Then, COD = Effective Yield = YTM = 7.20%(recall how to use calculator for computing YTM)


13/21

Cost of Debt: A Caveat


COD is the Effective Yield on Debt,

which equals YTM for annual coupon-payments

Recall that YTM isNOT the same as Current Yield OR Coupon Rate

In the previous example,COD = Effective Yield = YTM = 7.20%

whereas Coupon Rate = 10% and Current Yield = 8.70%


14/21

Cost and Value of Non-Traded Debt


What if the companys debt does not trade publicly?

Then, we dont have its price or value,

we cannot explicitly compute effective-yield

In such cases,look at Effective Yield of debt of other similar firms

Similar Similar in risk, rating, debt-ratio(possibly same or similar line of business)

How to compute value of debt here?

Discount interest-payments and par-values by

the Cost-of-Debt obtained above to get debt value;or else, take Book Value as substitute for Market Value


15/21

Computing Weighted COD


Though most firms typically have

one class of common shares,

They would have several issues of debt,

issued at different points of time in past,

with different times-to-maturity, coupon-rates

In such cases, we should compute

average Effective Yield (or YTM)


16/21

Market-Value and Cost of Debt


DERIVED BY US

Coupon Market-Value* % of Total YTM

weight

9.00% $25.32 mil 27.40 8.50%7.00% $67.08 mil 72.60 8.90%

Total $92.40 mill Weighted Average8.79%* Multiplying Amount (or Total Face Value) by Price gives the Market-Value

GIVEN DATACoupon Maturity Amount* Current-Price

9.00% 2010 $25 mil 101.28% (of par)

7.00% 2015 $75 mil 89.45%


17/21

Market-Value of Equity and Weights


Suppose the same Company hasone million shares outstanding,

each with a current price of $200

Then its Market Value of Equity =

$200 million

So, the Market-Value Debt-Equity-Ratio

= 92.40 / 200.00 = 46.20%

Moreover,

%40.68%60.31%100V

E

%60.3100.20040.92

40.92

V

D


18/21

Two Approaches for Cost of Equity


1. DGM (Dividend Growth Model)Easy to understand and use

BUT,

Does not explicitly take risk into account

AND

Difficult to estimate ifCompany not paying dividends

Dividends not growing at a steady rate

2. CAPM (or SML)

It takes risk explicitly into account

BUT,

Measure of risk (Beta) varies over time

AND

Estimation is sensitive to various factors


19/21

DGM Approach


gPDR

gR)g1(D

gRDP

t

1tE

E

t

E

1tt

Looks familiar? R = DY + CGY

So, COE (Cost of Equity) = RE = RRR = DY + g

g, the growth-rate, is

Estimated from historical data

OR taken from analysts forecasts

Suppose a company, whose dividends have been growing steadily @5%,

has just paid a dividend of $4.00, and its price now is $20.00What is the firms COE?

%26%500.20

%)51(00.4g

P

)g1(DRCOE

t

tE


20/21

CAPM or SML Approach


Ri = Rf+ i (RM - Rf)Need Three Variables:

Rf Current Treasury Rate (easily available)

i Obtained by regressing historical stock-return on market-return

(RM - Rf)Usually taken as equal to the historical spread

A company has a of 1.25;

Current Rf(Treasury Rate) is 6.00%,Historical RM - RfSpread has been 8.00%

COE = Ri = Rf+ i (RM - Rf) = 6% + (1.25 x 8%) = 16.00%


21/21

Cost of Preferred Stock


Typically a perpetuity,sometimes may be a growing perpetuity

Generic Formula:

where g, the growth rate, is typically zero

A firms preferred-shares,

that have been paying $2.50 dividend annually,

are selling now for $20.00

gP

D

RgR

D

Pt

1tP

P

1tt

%50.12000.20

50.2g

P

DR,So

t

1tP

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