3. Weighted Average Cost of Capital (WACC) Chap 12

Weighted Average Cost of Capital (WACC) Overview

• WACC, project-based costs of capital, and raising external capital are the main topics.

Firm's Capital Structure

• Capital is a component of a firm's capital structure.
• Capital structure is a mix of debt and equity used to finance a company's assets.
• A basic balance sheet includes assets, liabilities, and equity.
• Assets include current and long-term assets.
• Liabilities and equity include debt, preferred stock, and equity.
• Different firms can have very different capital structures.

Weighted Average Cost of Capital (WACC)

• The overall cost of capital considers weighted averages.
• WACC is calculated using a market-value balance sheet.
• Market Value of Equity + Market Value of Debt = Market Value of Assets
• Leverage is a key component in WACC calculations, which can be unlevered or levered.
• For an unlevered firm, WACC is the equity cost of capital.
• The WACC formula for a levered firm includes the fraction of firm value financed by equity and debt, as well as the cost of equity and debt.

Calculating Weights in WACC

• Weights represent the fractions of a company financed by debt and equity, based on market values.
• Market values, instead of book values, are used to determine the cost of capital
• For Kenai Corp, with $10 million in debt (trading at 95% face value) and 1 million shares trading at $30:
  • Debt market value is $9.5 million
  • Equity market value is $30 million
  • Total market value is $39.5 million
  • Debt weight is 24.1% (9.5 / 39.5)
  • Equity weight is 75.9% (30 / 39.5)
• Kenai will use a weighted average of debt and equity costs, with weights of 24.1% and 75.9%, respectively.

Cost of Debt Capital

• Includes yield to maturity, representing the return bond purchasers get if they hold the debt to maturity.
• It can estimate the firm’s current debt cost, which is what investors demand for holding the firm's new or existing debt.
• Considers the effective cost of debt after taxes.
• Effective cost of debt is calculated as rD(1 - TC), where TC is the corporate tax rate.
• For BCE, with a pretax cost of debt at 1.98% and a tax rate of 35%:
  • Effective cost of debt = 0.0198 * (1 - 0.35) = 1.287%
• For a new $1000 loan, BCE pays $19.80 in interest, but can deduct this from their income:
  • BCE saves $.35 per dollar in interest in taxes
  • Interest tax deduction reduced payment to government by 0.35 * 19.80 = $6.93
  • Net cost for $1000 of debt = $19.80-$6.93 = $12.87, 1.287%

Cost of Preferred Stock Capital

• Calculated as: Cost of Preferred Stock Capital = (Preferred Dividend) / (Preferred Stock Price)
• For BCE's preferred stock priced at $85.83 with an annual dividend of $3.50:
  • Cost of preferred stock = $3.50 / $85.83 = 4.08%

Cost of Common Stock Capital

• Determined using the Capital Asset Pricing Model (CAPM).
• Steps to apply the CAPM:
  • Estimate the beta of equity by regressing 60 months of company returns against 60 months of returns for a market proxy (e.g., S&P/TSX Composite Index).
  • Determine the risk-free rate using the yield on government treasury bills or bonds.
  • Estimate the market risk premium by comparing historical returns on a market proxy to contemporaneous risk-free rates.
  • Apply the CAPM formula: Cost of Equity = Risk-Free Rate + Equity Beta × Market Risk Premium
• Calculated using the Constant Dividend Growth Model.
• Cost of Equity = (Dividend(in one year) / Current Price) + Dividend Growth Rate
• Using the CAPM, assume an equity beta of 1.30, a ten-year Government of Canada bond yield of 3% and a market risk premium estimate of 6%: -BCE's cost of equity is 3% + (1.30 x 6%) = 10.8%
• Using the Constant Dividend Growth Model, assume an early-2016 forecast for the long-run earnings growth rate was 12.7%:
  • With an expected dividend in one year of $.92 and a price of $30.05
  • Cost of equity = $.92/$30.05 + 0.127 = .158, 15.8%

Estimating the Cost of Equity: Inputs

• CAPM: Equity beta, risk-free rate, and market risk premium
• CDGM: Current stock price, expected dividend next year, and the future dividend growth rate

Estimating the Cost of Equity: Major Assumptions

• CAPM: Estimated beta is correct, market risk is accurate, and CAPM is correct model
• CDGM: Dividend estimate is correct, growth rate matches market expectations, and future dividend growth is constant

Estimating Equity Cost of Equity Example

• For Johnson & Johnson (JNJ), with an estimated equity beta of 0.55, a 3% yield on 10-year treasuries, and a market risk premium of 6%, plus an annual dividend rate of $2.81, and a stock price of $92.00:
• CAPM: Equity cost = 3.0% + .55*6% = 6.3%
• CDGM: Equity cost = $2.81/$92 + 4% = 7.1%
• With different methods, the ultimate answers can differ.
• Assumptions should be examined to decide which set is most realistic when approaches produce different answers.
• To align answers, the growth rate must be assumed.
• Rearranging the CDGM, DividendGrowthRate = Cost of Equity - (Dividend(in one year) / Current Price)
• DividendGrowthRate = 6.3%-3.1%=3.2%
• If dividends are expected to grow at a rate of 3.2% per year, the approaches would produce the same cost of equity estimate.

Weighted Average Cost of Capital (WACC) Equation

• Considers all capital sources:
  • rwacc = rEE% + rpfd P% + rD(1 - TC)D%
• For a company without preferred stock:
  • rwacc = rEE% + rD(1 - TC)D%

WACC in Practice

• For BCE in 2016, with common stock at $276,880 million, preferred stock at $6,000 million, and debt at $198,270 million, and costs of common stock, preferred stock, and debt already computed:
  • Total value is $481,150 million

Computing the WACC Example

• Target has an expected return on equity of 11.5% and a yield to maturity on debt of 6%.
• Debt accounts for 18% and equity for 82% of the total market equity.
• The tax rate is 35%.
  • WACC = (0.115)(0.82) + (0.06)(1-0.35)(0.18) = 10.1%
• Formula allows WACC estimates using expected return on equity and debt
• For its debt and equity holders, Target needs to earn 10.1% on investments to satisfy

Methods in Practic

• Net Debt=debt - cash and risk free securities
• rWACC=rE (Market value of equity/ enterprise value)+rD(1-TC)(Net Debt/ Enterprise value)

Market Risk Premium

• Since 1950, S&P/TSX composite index average return 6% above the Canadian Treasury Bills.
• Since 1962, S&P 500 excess return of 5.5% over rate of 1 year treasure securities.

Using the WACC to Value a Project

• Levered value includes the interest tax deduction
• WACC valuation method is discounting incremental cash flows using a firms WACC producing a levered value of a project

The WACC Method Example

• Anheuser-Busch InBev is thinking about introducing a beer with zero calories called BudZero. The beer appeals to calorie conscious drinkers.
• It costs $200 million
• First year cash flow $100 billion growing at 3% after.
• InBev,s WACC is 5.7 percent
• BudZero has Cash Flows that are growing perpetuity.
• V0L FCF  = − $200 million + (100 Million/0.057-0.03) = ($3.5 Billion)

Using the WACC to Value a Project: Key Assumptions

• Average risk is that market risk is equal to investment of the firm.
• Constant debt equity ratio is assumed that firm adjusts continuously to maintain constant ration of debt and equity
• Limited Leverage Effects= it assumes that tax deduction for interest is important and others aren't significant relative to debt level.

Project-Based Costs of Capital

• GE is considering buying Nike, Nike faces market risks that GE doesn't
• GE should estimate Nikes WACC and it is inappropriate to value Nike

A Project in a New Line of Business Example: Microsoft

• Microsoft is looking at selling DVR's
• WACC is 8.6%
• Systematic risk differs, new Cost of Capital also needed to be found if DVR
• Risk Free Rate (3%); Market Risk Premium is 6%.
• Tivo is related; look to that company for information.