Weighted Average Cost of Capital
The Weighted Average Cost of Capital is the rate that a firm is required to make to be able to pay its obligations.
For example, if a company has a WACC of 18%, then it would reject projects and investments that would only delive
Perhaps it only owes 8% on its debt but owes 20% on its equity, but because it has much more common stock issue
It is the default cost of capital used for investment decisions of levered firms. (levered meaning having debt)
WACC is a cost of capital that takes into consideration: 1. Debt/Equity capital structure
2. Cost of Debt
3. Cost of Equity (determined by CAPM)
4. Tax Rate
Here is the formula:
WACC= (% portion of capital that is equity) x (Cost of Equity) + (% portion of cap
It's extremely important to remember to multiply the debt portion and cost with (1-
This is because there is a quirk in the US tax code that makes corporate interest paym
Although debt is cheaper, it has its disadvantages as well as can be read in the Capita
Before we begin going through the steps in detail, here is a very brief example:
-
-
WACC=(Equity%)*(Cost
WACC=(80%)*(20%)+(2
WACC=17.17%
Step 1. Find Corporate Tax Rate.
US Cor
As you can see from the chart to the right, the US Earnings before Taxes (EBT)
charges a corporate tax depending on income. $0 - $50,000
$50,000 - $75,000
Most companies we'll be analyzing are taxed at the $75,000 - $100,000
flat 35% rate. The actual taxable amount is considered $100,000 - $335,000
"Earnings Before Taxes" on the income statement. This is $335,000 - $10,000,000
considerably smaller than "Sales" since all $10,000,000 - $15,000,000
expenses have been taken out (including depreciation) $15,000,000 - $18,333,333
which greatly benefits companies much property or Over $18,333,333
equipment.
Sometimes corporations receive tax breaks. If this is a normal occurrence (according to their income statement) take a
35% WACC=(E/V)*Ce+(D/V)*Cd*(1-0.35)
Step 2. Determine Debt/Equity Capital Structure.
The market values of debt and equity need to be found.
1. To find the market value of equity simply multiply the stock price by the amount of
shares outstanding.
If the current price of the stock is $45, then we will multiply that by total shares.
=1,000,000*45
$45,000,000 Market Value of Equity, called the "Market Cap"
Note: When doing this calculation use the most recent quarterly balance sheet to find
total debt. For consistency we must get a stock price from the same time (check historical price).
2. Finding the market value of debt is much trickier since it's mostly held by other
companies and funds and is not public information. So we will estimate the
weight of the debt by using its book value (all debt liabilities on the balance sheet).
Portion of debt= Debt Book Value/(Market Value of Equity + Debt Book Value)
=$35/($45+$35)
44% Portion or weight of debt
Since we know the % of debt, we instantly know that the portion of equity is 60%
Equity weight=1-Debt weight
Debt/Value= 44%
Equity/Value= 56% WACC= (0.5625)*Ce+(0.4375)*Cd*(0.65)
Step 3. Find Cost of Debt.
This can be done multiple ways. To see an alternate method using credit ratings:
1. Add up the debt on the balance sheet.
Simple Balance Sheet
Current+Long Term Liabilities= Assets
$35 Cash $ 20
Accounts Receivable $ 100
Liabilities
Current Liabilities $ 5
Long Term Liabilities $ 30
Equity
Common Stock $ 85
1 MM shares outstanding
3. These two figures tell us how much the firm is paying on its total debt. We can assume its next dollar of debt will cost
Divide the interest expense by total debt liabilities
Cost of Debt 8.57% WACC= (0.5625)*Ce+(0.4375)*0.0857*(0.65)
Step 4. Find Cost of Equity.
CAPM is used to estimate the firm's cost of equity. For a more detailed explanation go to the CAPM lesson.
Find firm beta= 1.2 This is a measure of the firm's market risk.
Find Risk Free Rate= 3% This is usually the 10 year US treasury rate.
Find Market Risk Premium= 5% This is how much the stock market has historica
Plug these numbers into the CAPM formula: Cost of Equity=Risk Free Rate+(Beta)*(Market Risk Premium)
CAPM= =.03+(1.2)*.05
CAPM= 9.00%
WACC=(0.5625)*0.09+(0.4375)*0.0857*(0.65)
WACC 7.50%
We can use the company WACC as the the project is, etc. This part is projects. In practice, premiums are added to the
on what managers think, how untested base discount rate for all of its highly subjective.
managers think, how untested the project is, etc. This part is highly subjective.
be able to pay its obligations.
d investments that would only deliver a 17% return.
has much more common stock issued than bonds, it owes 18% on average.
red meaning having debt)
uity capital structure
quity (determined by CAPM)
x (Cost of Equity) + (% portion of capital that is debt) x (Cost of Debt) x (1-Tax Rate)
y the debt portion and cost with (1-tax rate). This is called "finding the after tax cost of debt".
e that makes corporate interest payments tax deductible. This makes debt cheaper.
s as well as can be read in the Capital Structure lesson in investment banking.
WACC Calculation
-A software company has a 35% corporate tax rate, a cost of debt of 9%, and an equity cost of 20%.
-It's equity has a market value of $400M and debt with a market value of $100M.
WACC=(Equity%)*(Cost of Equity) + (Debt%)*(Cost of Debt)*(1-Tax Rate)
WACC=(80%)*(20%)+(20%)*(9%)*(1-35%)
WACC=17.17%
US Corporate Tax Chart 2012
Earnings before Taxes (EBT) Progressive Tax Rates
$0 - $50,000 15%
$50,000 - $75,000 $7,500 + 25% of excess over $50,000
$75,000 - $100,000 $13,750 + 34% of excess over $75,000
$100,000 - $335,000 $22,250 + 39% of excess over $100,000
$335,000 - $10,000,000 $113,900 + 34% of excess over $335,000
$10,000,000 - $15,000,000 $3,400,000 + 35% of excess over $10,000,000
$15,000,000 - $18,333,333 $5,150,000 + 38% of excess over $15,000,000
Over $18,333,333 Flat 35%
ng to their income statement) take a 3 year average of the actual tax rates used.
A firm's "target" capital structure should be used but many times this is not available.
Simple Balance Sheet
Assets
Cash $ 20
Accounts Receivable $ 100
Liabilities
Current Liabilities $ 5
Long Term Liabilities $ 30
Equity
istorical price). Common Stock $ 85
1 MM shares outstanding
Notice:Current and Long Term liabilities are added to come up with debt book value.
Cost of Debt-Credit Ratings The easiest and most commonly used is demonstrated below.
2. Find total interest expenses on income statement.
Simple Income Statement
Interest Expense= Sales $ 50.00
$3.00 Operating Expenses $ (10.00)
Depreciation $ (1.00)
Interest Expense $ (3.00)
EBT $ 36.00
Taxes $ (12.60)
Net Income $ 23.40
Very Important!
If the interest expense line says "net interest expense", you MUST find
out how much the firm gained from interest income, and subtract it
out. This can usually be found in the notes of the 10K Annual Report.
sume its next dollar of debt will cost this much.
n go to the CAPM lesson.
asure of the firm's market risk.
ly the 10 year US treasury rate.
much the stock market has historically paid out over the risk free rate.
*(Market Risk Premium)
practice, premiums are added to the cost of capital depending on what
Calculating Cost of Debt using Credit Ratings
1. If we know a company's credit rating, we can find its cost of debt. Credit ratings can sometimes be found on a firm's w
available in their 10K annual report. A quicker way to access multiple ratings would be to register for free at one of th
2. Look up the 20 year corporate bond rate for the company in question.
Let's choose Microsoft (MSFT) which has a AAA rating.
A quick visit to Yahoo! Finance will give us the rating for AAA. Unfortunately, many of the ratings
are unlisted on the free sites like Yahoo. If your company does not give you access to a paid subscription service
then you can estimate (If the rating is AA1 then you can use the composite AA amount available, and average it with t
Corporate Bonds from Yahoo Finance Bond Center
AAA (as of 7/27) has rate of 5.17% Maturity Yield Yesterday Last Week
2yr AA 0.97 0.96 0.95
Cost of Debt 5.17% 2yr A 1.17 1.2 1.18
5yr AAA 1.87 1.79 1.75
5yr AA 2.6 2.64 2.66
5yr A 2.8 2.86 2.83
10yr AAA 3.12 3.1 3.18
10yr AA 4.06 3.99 3.95
10yr A 3.97 3.88 3.85
20yr AAA 5.17 5.13 5.09
20yr AA 5.51 5.47 5.44
20yr A 5.33 5.29 5.26
metimes be found on a firm's website under "investor relations." If not, it will be
e to register for free at one of the ratings agencies. Moody's S&P Fitch
List of investment grade credit ratings: AAA
Anything rated below BAA3 is considered speculative. AA1
AA2
AA3
A1
A2
a paid subscription service A3
available, and average it with the AAA rating). BAA1
BAA2
nce Bond Center BAA3
Last Month
0.97
1.21
1.69
2.5 What if we're finding the WACC of a company like
2.78 Citigroup (C) which has a rating of A3?
3.22 •Start with the rate for A which is 5.33
4.11 •Find the average difference between the 20 year yields
4 •Apply the average amount deducted to your unlisted rating
5.04
5.38
5.2
Input in yellow cells
Equity Debt
Stock Price $11.24 Book Value of Debt $5,000,000.00
Shares Outstanding 1000000
Market Capitalization $11,240,000 Debt Market Value $5,000,000
Cost of Equity Cost of Debt
Company Beta 0.98 Interest Expense $200,000
Risk Free Rate 3% Total Debt Outstanding $3,000,000.00
Market Risk Premium 6%
Cost of Equity 9% Cost of Debt 7%
Tax Rate 35%
WACC 7.62%
Shortcut Calculator
% Debt 40%
% Equity 60%
Cost of Debt 7%
Cost of Equity 10%
Tax Rate 35%
WACC 7.82%
Capital Structure
Debt Capital 31%
Equity Capital 69%