Definition of WACC
Weighted Average Cost of Capital (WACC) of a firm represents its combination of common shares, preferred shares, and debt. The cost of each type of capital is weighted by its % of total capital and they are added together. WACC is used in financial modelling as the discount rate to calculate the Net Present Value (NPV) of a business.
WACC = Cost of equity + Cost of Debt
Where:
Cost of equity = (Equity risk premium x Beta) + Risk free rate
Cost of debt (after tax) = [Average yield on debt x (1 – Tax
rate)]
Here, (1 – Tax rate) means Tax shield
WACC = (E/V x Re) +
[(D/V x Rd) x (1 – T)]
Where:
E = market value of the firm’s equity
market cap
D = market value of the firm’s debt
V = total value of capital (equity plus debt)
E/V = percentage of equity capital
D/V = percentage of Debt capital
Re = cost of equity at
required rate of return
Rd = cost of debt (i.e. yield to maturity on existing debt)
T = tax rate
WACC = (Cost of equity x % of equity) + [(Cost of debt x % of debt) x (1-tax rate)] + Cost of preferred stock x % of preferred stock)
The
purpose of WACC is to determine the cost of each part of the company’s capital
structure based on the proportion of equity, debt, and preferred stock it
has. Each component has a cost to the company. The company pays a fixed rate
of interest on its debt and a fixed yield on its preferred stock.
Even though a firm does not pay a fixed rate of return on common equity, it does
often pay dividends in the form of cash to equity holders. The
weighted average cost of capital is an integral part of a DCF valuation
model, and thus, it is an important
concept to understand for finance professionals, especially for investment
banking and corporate development roles.
Cost
of Equity
The
cost of equity is calculated using the Capital Asset Pricing Module (CAPM)
which equates rates of return to volatility i.e. risk vs reward.
Cost of equity (Re) =
Rf + [β × (Rm − Rf )]
Where:
Rf = Risk-free rate
(typically the 10-year U.S. Treasury bond yield)
β = Beta of equity (levered)
Rm = Annual return of the market
The
Cost of equity is an implied cost or an opportunity cost of capital. It is the
rate of return that shareholders require i.e. in order to compensate them for
the risk of investing in the stock. The Beta is a measure of a stock’s
volatility of returns relative to the overall market i.e the respective
benchmark index of that stock. It can be calculated by using historical
return data.
Risk-free Rate
The risk-free
rate is the return that can be earned by investing in a risk-free
security, e.g., U.S. Treasury bonds. Typically, the yield of the 10-year U.S. Treasury is
used for the risk-free rate.
Equity Risk Premium
Equity
Risk Premium is defined as the extra yield that
can be earned over the risk-free rate by investing in the stock market. One
simple way to estimate Equity Risk Premium is to subtract the risk-free return
from the market return. This information will normally be enough for most basic
financial analysis. However, in reality, estimating Equity Risk Premium can be
a much more detailed task. Generally, banks take Equity Risk Premium from a
publication called Ibbotson’s.
Levered Beta
Beta refers to the volatility (or riskiness) of a stock relative
to all other stocks in the market (i.e. bench mark index of that stock). There
are a couple of ways to estimate the beta of a stock. The first and simplest
way is to calculate the company’s historical beta (using regression analysis) or just pick up
the company’s regression beta from Bloomberg. The second and more thorough approach is to make a new estimate
for beta using public company comparable. To use this approach, the beta of comparable companies is taken
from Bloomberg and the unlevered beta for each company is calculated.
Unlevered Beta = Levered Beta / [{1 + (1 – Tax Rate)} x (Debt /
Equity)]
Levered Beta = Unlevered Beta x [{1 + (1 – Tax Rate)} x (Debt /
Equity)]
The
average of the unlevered beta is then calculated and re-levered based on the
capital structure of the company that is being valued. In most cases, the
firm’s current capital structure is used when beta is re-levered. However, if
there is information that the firm’s capital structure might change in the
future, then beta would be re-levered using the firm’s target capital
structure. After calculating the risk-free rate, equity risk premium, and
levered beta, Cost of equity = [Risk-free rate + (equity
risk premium x levered beta)].
Cost
of Debt and Preferred Stock
Determining
the cost of debt and
preferred stock is probably the easiest part of the WACC calculation. The cost
of debt is the yield to maturity on the firm’s debt and similarly, the cost of
preferred stock is the yield on the company’s preferred stock. Simply multiply
the cost of debt and the yield on preferred stock with the proportion of debt
and preferred stock in a company’s capital structure, respectively. Since interest
payments are tax-deductible, the cost of debt needs to be multiplied by (1 –
tax rate), which is referred to as value of the tax
shield. This is not done for preferred stock
because preferred dividends are paid with after-tax
profits. Take the weighted average current
yield to maturity of all outstanding debt then multiply it by (1 - tax rate)
and you have the after-tax cost of debt to be used in the WACC formula.
What
is WACC used for?
The
Weighted Average Cost of Capital (WACC) serves as the discount rate for
calculating the Net Present Value
(NPV) of a business. It is also used to evaluate
investment opportunities, as it is considered to represent the firm’s
opportunity cost. Thus, it is used as a hurdle rate by companies. A company
will commonly use its WACC as a hurdle rate for evaluating Mergers and Acquisitions (M&A), as well as for financial modeling
of internal investments. By knowing WACC, if an investment
opportunity has a lower Internal Rate of Return (IRR) than its WACC,
it should buy back its own shares or pay out a dividend instead of investing in
the project.
Nominal
vs Real Weighted Average Cost of Capital
Nominal free cash flows (which include inflation) should be discounted by a nominal WACC and real free cash flows
(which exclude inflation) should be discounted by a real weighted average cost
of capital. Nominal is most common in practice, but it is important to be
aware of the difference.
------------------------------- The end -------------------------
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