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17.3 Calculating the Weighted Average Cost of Capital

4 min read•june 18, 2024

The is a crucial concept in finance that measures a company's overall cost of financing. It considers the mix of debt and equity used to fund operations, weighing each source's cost by its proportion in the .

Calculating WACC involves several methods for estimating equity costs, including the and . Understanding 's impact on WACC and the relationship between and is essential for making informed financial decisions.

Weighted Average Cost of Capital (WACC)

Calculation of weighted average cost of capital

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  • WACC represents the overall cost of financing a company's assets by considering the proportions and costs of debt and equity financing (loans, bonds, common stock, )
  • Formula: WACC=wdrd(1−t)+wereWACC = w_d r_d (1 - t) + w_e r_e
    • wdw_d: proportion of debt in the indicates the percentage of financing from debt sources
    • rdr_d: reflects the on existing debt or current market rates for new debt issuance
    • tt: accounts for the tax deductibility of interest expenses, which reduces the effective cost of debt ()
    • wew_e: proportion of equity in the capital structure indicates the percentage of financing from equity sources
    • rer_e: represents the required rate of return for equity investors based on the risk they bear
  • Debt is typically cheaper than equity due to tax deductibility of interest, which lowers the effective cost, and lower risk as debt holders have priority claims on assets and income
  • Equity is more expensive than debt due to higher risk borne by equity holders, who are residual claimants, and lack of tax benefits associated with equity financing
  • Changes in capital structure affect WACC, as increasing debt generally lowers WACC up to a point, as debt is cheaper than equity, but excessive debt increases financial risk and can raise both debt and equity costs (interest rates, required returns)
  • The influences the WACC calculation by determining the optimal mix of debt and equity financing

Methods for estimating equity capital cost

  • estimates the cost of equity based on the stock's sensitivity to market risk
    • Formula: re=rf+β(rm−rf)r_e = r_f + \beta (r_m - r_f)
      • rfr_f: represents the return on a theoretically risk-free investment (government bonds)
      • β\beta: beta coefficient measures the stock's relative to the market (S&P 500 index)
      • rmr_m: expected market return is the average return expected from the broad market portfolio
    • Assumes investors are well-diversified and only require compensation for that cannot be diversified away
    • Limitations: relies on historical data to estimate beta and , assumes market efficiency, and requires subjective estimates of the expected market return
  • calculates the cost of equity based on expected future dividends and stock price
    • Formula: re=D1P0+gr_e = \frac{D_1}{P_0} + g
      • D1D_1: expected dividend per share in the next period based on the company's dividend policy
      • P0P_0: current stock price observed in the market
      • gg: expected assuming constant growth, estimated using historical data or analyst projections
    • Assumes that the value of a stock equals the present value of its future dividends discounted at the cost of equity
    • Limitations: requires estimating future dividends and growth rates, which are uncertain, and not suitable for non-dividend-paying stocks (startups, growth companies)
  • (BYPRP) method estimates the cost of equity by adding a risk premium to the company's long-term debt yield
    • Formula: re=Yd+RPr_e = Y_d + RP
      • YdY_d: yield on the company's long-term debt reflects the current cost of borrowing
      • RPRP: is a subjective estimate of the additional return required by equity investors over debt
    • Limitations: risk premium is subjective and may not accurately reflect the true risk differential between the company's debt and equity

Net debt's impact on WACC

  • is total debt minus cash and cash equivalents, representing the amount of debt that would remain if the company used all its cash to repay debt (loans, bonds)
  • When calculating WACC, use net debt instead of total debt in the capital structure to adjust for the fact that cash can be used to repay debt, reducing financial risk
  • Higher net debt increases financial risk and can raise both debt and equity costs, leading to a higher WACC (interest rates, required returns)
  • Lower net debt reduces financial risk and can lower both debt and equity costs, leading to a lower WACC
  • Changes in net debt can affect investment and financing decisions:
    1. Projects that increase net debt may become less attractive due to a higher WACC, making them less likely to be pursued
    2. Financing decisions that reduce net debt, such as issuing equity or using cash to repay debt, may lower WACC and make more projects viable by reducing the hurdle rate for investment

Financial leverage and opportunity cost

  • Financial leverage refers to the use of debt to finance a company's operations and affects the WACC through its impact on the capital structure
  • in WACC represents the return investors could earn on alternative investments with similar risk profiles
  • The nature of WACC accounts for the different costs and proportions of various financing sources

Key Terms to Review (56)

After-tax cost of debt: After-tax cost of debt is the net cost a company incurs on its debt after accounting for tax deductions. It is an important measure as interest expenses are tax-deductible, reducing the overall expense of borrowing.
After-Tax Cost of Debt: The after-tax cost of debt represents the effective cost of borrowing money for a company, taking into account the tax benefits associated with debt financing. It is a crucial consideration in determining a firm's weighted average cost of capital (WACC).
American Airlines: American Airlines is one of the largest airline companies in the United States, offering domestic and international flights. It is a publicly traded company that raises capital through equity and debt financing to fund its operations and expansion.
AT&T: AT&T is a major American multinational telecommunications company. It provides a wide range of services, including wireless communications, digital entertainment, and business communications solutions.
Beta: Beta measures the volatility or systematic risk of a security or portfolio relative to the overall market. A beta greater than 1 indicates more volatility than the market, while a beta less than 1 indicates less volatility.
Beta: Beta is a measure of the volatility or systematic risk of a financial asset or portfolio in relation to the overall market. It represents the sensitivity of an asset's returns to changes in the market's returns, providing a quantitative assessment of an investment's risk profile.
Bond Yield Plus Risk Premium: The bond yield plus risk premium is the total expected return that an investor requires to hold a bond, which is the sum of the risk-free rate of return (the bond yield) and the additional compensation for taking on the risk associated with that bond (the risk premium). This concept is crucial in understanding the weighted average cost of capital (WACC) for a company.
Capital Asset Pricing Model: The Capital Asset Pricing Model (CAPM) is a financial model that describes the relationship between the expected return of an asset and its risk. It provides a framework for understanding how the market values an asset based on its systematic risk, which is measured by the asset's beta. CAPM is a fundamental concept in finance that is widely used in investment analysis, portfolio management, and corporate finance decision-making.
Capital asset pricing model (CAPM): The Capital Asset Pricing Model (CAPM) is a financial model that describes the relationship between systematic risk and expected return for assets, particularly stocks. It is widely used to estimate an investment's required rate of return based on its risk relative to the market portfolio.
Capital Asset Pricing Model (CAPM): The Capital Asset Pricing Model (CAPM) is a financial model that describes the relationship between the expected return of an asset and its risk. It is used to price risky securities and to determine the appropriate required rate of return for assets given their risk.
Capital structure: Capital structure is the mix of debt and equity that a firm uses to finance its operations and growth. It directly impacts the company's risk, cost of capital, and overall financial strategy.
Capital Structure: Capital structure refers to the mix of debt and equity financing that a company uses to fund its operations and investments. It represents the relative proportions of different sources of capital, such as short-term debt, long-term debt, and equity, that a company employs to finance its assets and activities. The capital structure of a company is a crucial aspect of corporate finance, as it directly impacts the company's financial risk, cost of capital, and ultimately, its overall value and performance.
Coca-Cola: Coca-Cola is a multinational beverage corporation known for its flagship product, Coca-Cola soda. It operates in more than 200 countries and involves extensive financial activities including bond issuance and capital raising.
Common Equity: Common equity represents the ownership interest in a company that is held by its common shareholders. It is the residual claim on a company's assets and earnings after all other claims, such as debt and preferred stock, have been satisfied. Common equity is a crucial component in calculating a company's weighted average cost of capital (WACC).
Cost of Debt: The cost of debt refers to the effective interest rate a company pays on its borrowed funds, such as loans or bonds. It is a crucial factor in calculating a company's weighted average cost of capital (WACC), which is a key metric used in financial analysis and decision-making.
Cost of Equity: The cost of equity represents the return that investors require as compensation for the risk of investing in a company's common stock. It is a crucial component in calculating a company's weighted average cost of capital (WACC), which is used to evaluate investment decisions and assess a firm's overall cost of capital.
Debt-to-equity ratio: The debt-to-equity ratio is a solvency ratio that measures the proportion of a company's debt to its shareholders' equity. It indicates how much debt a company is using to finance its assets relative to the value represented in shareholders’ equity.
Debt-to-Equity Ratio: The debt-to-equity ratio is a financial metric that measures a company's financial leverage by dividing its total liabilities by its total shareholders' equity. This ratio provides insight into a company's capital structure and its ability to meet its financial obligations.
Discounted Cash Flow: Discounted cash flow (DCF) is a valuation method used to estimate the present value of a company's future cash flows. It is a fundamental concept in finance that considers the time value of money, where future cash flows are discounted to their present worth using an appropriate discount rate.
Discounted cash flow (DCF): Discounted Cash Flow (DCF) is a valuation method used to estimate the value of an investment based on its expected future cash flows. The future cash flows are adjusted for the time value of money using a discount rate.
Dividend Discount Model: The dividend discount model (DDM) is a method for valuing the price of a stock by using the predicted dividends and discounting them back to the present value. It is based on the premise that the intrinsic value of a stock is the present value of all expected future dividend payments.
Dividend discount model (DDM): The Dividend Discount Model (DDM) is a method used to value a stock by discounting predicted future dividend payments to their present value. This model assumes that dividends are the primary source of a stock's value.
Dividend Growth Rate: The dividend growth rate refers to the rate at which a company's dividend payments increase over time. It is an important consideration for investors evaluating the potential returns from a stock investment, as a higher dividend growth rate can lead to greater long-term income and capital appreciation.
Equity Risk Premium: The equity risk premium is the additional return that investors expect to receive for holding riskier equity investments compared to the return from risk-free assets. It represents the compensation for taking on the higher level of risk associated with investing in the stock market rather than safer investments like government bonds.
Financial Leverage: Financial leverage refers to the use of debt or other financial instruments to increase the potential return on an investment. It involves using borrowed funds to finance a project or purchase, with the goal of magnifying the potential gains (or losses) compared to using only one's own capital.
Goodyear Tire and Rubber: Goodyear Tire and Rubber is a multinational tire manufacturing company founded in 1898. It is one of the largest tire companies globally, supplying products for various vehicles including cars, trucks, motorcycles, airplanes, and industrial equipment.
Gordon growth model: The Gordon Growth Model (GGM) is a method used to determine the intrinsic value of a stock based on a series of future dividends that are expected to grow at a constant rate. It assumes that dividends will continue to increase at a stable growth rate indefinitely.
Gordon Growth Model: The Gordon Growth Model is a valuation method used to estimate the intrinsic value of a stock by discounting the expected future dividends at a rate that accounts for the company's growth rate and cost of capital. It is a fundamental approach to stock valuation that is widely used in finance and investment analysis.
IBM: IBM (International Business Machines Corporation) is a global technology and consulting company known for its hardware, software, and service solutions. In finance, it serves as an example of a large corporation raising capital through various means such as equity, debt, and hybrid instruments.
KB Homes: KB Homes is one of the largest home-building companies in the United States, specializing in designing and constructing residential properties. It raises capital through various means including equity, debt, and retained earnings to fund its projects and operations.
Kraft Heinz: Kraft Heinz is a global food and beverage company formed by the merger of Kraft Foods Group and H.J. Heinz Company in 2015. It is publicly traded and has a diverse portfolio of well-known brands, impacting its capital structure and financing strategies.
Kroger: Kroger is a large American retail company that operates supermarkets and multi-department stores. It is one of the largest grocery chains in the United States by revenue and number of locations.
Levered Beta: Levered beta is a measure of the systematic risk of a company's stock that takes into account the impact of debt financing on the company's overall risk profile. It reflects the sensitivity of the company's stock returns to changes in the overall market returns, considering the company's capital structure.
Marginal Tax Rate: The marginal tax rate is the tax rate applied to the next dollar of taxable income. It represents the additional amount of tax owed on each additional unit of income earned, and it is a crucial concept in understanding the costs of debt and equity capital as well as the calculation of the weighted average cost of capital.
Market Risk Premium: The market risk premium is the additional return that investors expect to receive for holding a diversified portfolio of risky assets, such as stocks, rather than a risk-free asset like government bonds. It represents the compensation investors demand for taking on the additional risk of investing in the overall market.
MarketWatch: MarketWatch is a financial news website that provides business news, analysis, and stock market data. It is widely used by investors to track market trends and make informed investment decisions.
Modigliani-Miller Theorem: The Modigliani-Miller theorem is a fundamental principle in corporate finance that states the value of a firm is independent of its capital structure, meaning the way a firm finances its operations through debt or equity has no effect on its overall value. This theorem is a crucial concept in understanding capital structure choices and the optimal capital structure for a firm.
Net debt: Net debt is the total amount of a company's debt minus its cash and cash equivalents. It is used to measure a company's ability to pay off its debts if they were all due immediately.
Net Debt: Net debt is a measure of a company's overall debt position, calculated by subtracting the company's cash and cash equivalents from its total debt. It provides a more comprehensive view of a company's financial leverage and liquidity compared to just looking at total debt alone.
Opportunity cost: Opportunity cost is the value of the next best alternative that is forgone when making a decision. It represents the benefits you could have received by taking an alternative action.
Opportunity Cost: Opportunity cost is the value of the next best alternative that must be forgone in order to pursue a certain action or decision. It represents the trade-offs involved in allocating limited resources to one use instead of another.
Preferred stock: Preferred stock is a type of equity security that gives shareholders preferential treatment regarding dividends and asset liquidation. It typically does not provide voting rights in corporate decisions.
Preferred Stock: Preferred stock is a type of equity security that provides shareholders with certain preferences over common stockholders. These preferences typically include priority in dividend payments and asset distribution in the event of liquidation.
Risk-free rate: The risk-free rate is the theoretical return on an investment with zero risk of financial loss. It typically represents the interest rate on short-term government securities, like U.S. Treasury bills, considered free from default risk.
Risk-Free Rate: The risk-free rate is the theoretical rate of return of an investment with zero risk. It represents the interest rate on an asset considered to have no default risk, such as U.S. Treasury bills. This rate is a critical component in various financial models and concepts, including the Discounted Cash Flow (DCF) Model, the Capital Asset Pricing Model (CAPM), the costs of debt and equity capital, and the Weighted Average Cost of Capital (WACC).
Systematic risk: Systematic risk is the risk inherent to the entire market or a market segment. It cannot be eliminated through diversification and is influenced by factors such as economic changes, political events, and natural disasters.
Systematic Risk: Systematic risk, also known as market risk or undiversifiable risk, is the risk inherent to the entire market or market segment, which cannot be mitigated through diversification. It is the risk that affects all assets and cannot be eliminated by holding a diversified portfolio.
Target Capital Structure: The target capital structure refers to the optimal mix of debt and equity financing that a company aims to maintain in order to minimize its weighted average cost of capital and maximize firm value. It represents the company's long-term financing strategy and guides its financing decisions.
Tax Shield: The tax shield refers to the reduction in income taxes that a company can achieve by taking on debt. When a company borrows money, the interest payments on that debt can be deducted from its taxable income, effectively reducing the amount of taxes the company has to pay. This reduction in taxes is known as the tax shield.
US Treasury bonds: US Treasury bonds (T-bonds) are long-term debt securities issued by the US Department of the Treasury. They have maturities ranging from 10 to 30 years and pay periodic interest until maturity.
US Treasury securities: US Treasury securities are debt instruments issued by the U.S. Department of the Treasury to finance government spending. They are considered one of the safest investments as they are backed by the full faith and credit of the U.S. government.
Weighted Average: A weighted average is a calculation that takes into account the relative importance or significance of each component in a set of data. It is commonly used in finance to determine the overall cost of capital for a company by considering the different sources of financing and their respective weights.
Weighted Average Cost of Capital (WACC): The Weighted Average Cost of Capital (WACC) is a financial metric that represents the blended cost of a company's various sources of capital, including debt and equity. It is a crucial concept in corporate finance that is used to evaluate the overall cost of financing a project or investment, and to determine the minimum required rate of return for a company's operations.
Yahoo! Finance: Yahoo! Finance is a comprehensive financial news and data platform that provides up-to-date information on stock markets, economic indicators, and personal finance. It also offers tools for tracking investments and analyzing market trends.
Yield to Maturity: Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. It is the discount rate that makes the present value of all future coupon payments and the bond's par value at maturity equal to the bond's current market price. YTM is a key concept in understanding the time value of money, bond characteristics, bond valuation, interest rate risks, and the cost of capital.
Yield to maturity (YTM): Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures. It is expressed as an annual percentage rate and takes into account the bond's current market price, par value, coupon interest rate, and time to maturity.
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Glossary
Glossary
17.4 Capital Structure Choices