Weighted Average Cost of Capital

8 Key excerpts on "Weighted Average Cost of Capital"

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  eBook - ePub

  Corporate Value Creation

  An Operations Framework for Nonfinancial Managers

  • Lawrence C. Karlson(Author)
  • 2015(Publication Date)
  • Wiley

    (Publisher)

  debt-to-equity ratio will increase as will the interest rate on recent tranches and at some point no more debt financing will be available. (2) It ignores the cost of equity. When the company runs out of debt financing it now looks at the cost of equity and this would require they only approve projects that promise returns in excess of the cost of equity. Unfortunately by this time the cost of equity will have increased as a result of the debt load to some higher level, say (14%). The problem this creates is an investment with a 13% return should be turned down because it would have to be financed with the 14% cost of equity. To avoid this situation, management needs to take into consideration all of the components of the company's capital structure when making investment decisions and its cost of capital should be calculated as a weighted average of the cost of debt and equity used in the business. This concept is known as the Weighted Average Cost of Capital (WACC).

  Much theoretical work has been done in this area and therefore calculating a company's WACC can be either an involved or a relatively simple process. The approach taken in this chapter is a middle-of-the-road approach.

  Weighted Average Cost of Capital Defined

  As its name implies, the WACC is a weighted average of the cost of the various kinds of capital a company uses to finance its operations. Generally speaking it is the weighted average of two kinds of capital: debt and equity.

  A generalized equation for estimating a company's WACC is:1

  [3-1]

  where:

  • k
    i
    is the cost of the ith component of the capital structure and w
    i
    is the weighting of the ith type of capital

  If a firm's capital structure consisted of one class of debt, preferred equity, and common equity, then the generalized equation would reduce to:

  [3-2] k

  WACC

  = k

  B

  w

  B

  + k

  PE

  w

  PE

  + k

  CE

  w

  CE

  where:

  • the subscripts B, PE, and CE refer to debt, preferred equity, and common equity respectively

  When a company has only one class of debt and no preferred equity, Equation [3-2] becomes:

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  Finance for IT Decision Makers

  A practical handbook

  • Michael Blackstaff(Author)
  • 2012(Publication Date)
  • BCS, The Chartered Institute for IT

    (Publisher)

  Lenders to a company will usually be prepared to accept a lower return than shareholders, because lending is less risky. There are two reasons for this. First, payment of interest on a loan is compulsory, while dividends are not. Second, lenders have more security than do shareholders. They have a higher priority for getting paid when a company is wound up, so they stand more chance of getting their money back should it fail.

  Weighted Average Cost of Capital (WACC)

  So, what is a particular company’s cost of capital? It is a combination of its cost of equity and its cost of debt. If there were equal quantities of equity and debt, then the cost of capital would be the average of the two. Because the respective quantities are usually unequal, a weighted average is required. So, a company’s cost of capital is the weighted average of its costs of equity and debt. The following example illustrates the calculation and introduces the effect of tax.

  Let us assume for simplicity that a company has CU3 million of equity and CU1 million of debt. The total capital employed is therefore CU4 million. Suppose that the ‘cost of equity’ is 12 per cent per annum and the cost of debt eight per cent. What is the company’s current ‘cost of capital’? The calculation is as follows:

  (3 / 4 × 12) + (1 / 4 × 8) = 9 + 2 = 11%

  Therefore the basis of the discount rate used by this particular company in discounted cash flow calculations would be 11 per cent, but only if the company ignores tax in such calculations. Dividends are paid out of already-taxed profit. Interest on business loans, however, unlike interest on personal loans, is usually an expense deductible in arriving at profit. Therefore, the true cost of loan interest is not its gross cost but its net-of-tax cost. If the tax rate paid by the above company is, for example, 30 per cent, then the net-of-tax cost is not eight per cent but 5.6 per cent. To arrive at the after-tax cost of capital, the above calculation would be restated as follows:

  (3 / 4 × 12) + (1 / 4 × 5.6) = 9 + 1.4 = 10.4%

  Not all organisations are taxable and not all businesses take tax into account in investment evaluations. However, many do, and that is why a chapter on tax (Chapter 7

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  The Fundamental Principles of Finance

  • Robert Irons(Author)
  • 2019(Publication Date)
  • Routledge

    (Publisher)

  When a firm borrows money (issues new debt), both its financial leverage and its financial risk increase. When a firm issues new common equity, its financial leverage decreases. If the firm issues both new debt and new equity, keeping the ratio of debt and equity relatively constant, then financial leverage remains fairly stable. As will be seen, each source of funds (debt vs. preferred equity vs. new common equity vs. retained earnings) has different costs. Therefore, firms are motivated to (A) use the mix of sources that results in the lowest overall cost of funds and (B) maintain that relationship between the sources over time to stabilize both their costs and their financial leverage. The overall cost of funds, weighted according to the firm’s use of the sources of funds, is known as the Weighted Average Cost of Capital, or WACC. The formula for calculating the WACC is:

  W A C C =

  W d

   

  k d

  (

  1 − T

  )

  +

  W p

   

  k p

  +

  W e

   

  k

  e o r n

  • where:W
    d
    is the percentage of debt used in the capital structure;
  •     W
    p
    is the percentage of preferred equity used in the capital structure;
  •     W
    e
    is the percentage of common equity used in the capital structure;
  •     k
    d
    is the component cost of debt (the appropriate interest rate);
  •     k
    p
    is the component cost of preferred equity;
  •     k
    e
    is the component cost of common equity using retained earnings;
  •     k
    n
    is the component cost of new common equity (floating new shares); and
  •     T is the firm’s marginal tax rate.

  Notice that the cost of common equity is given in two different forms: the cost of retained earnings (k

  e

  ) and the cost of issuing new common equity (k

  n

  ). As will be seen, these two sources have different costs, and therefore need to be treated separately.

  Two important things to understand about this model:

  1. For the cost of common equity, k
     e
     is used in the model before k
     n
     because retained earnings are cheaper than new common equity (k
     n
     is used when the firm runs out of retained earnings); and
  2. The weights (W
     d
     , W
     p
     and W
     e
     ) must sum to 100%.

  The firm’s capital is supplied by its shareholders (owners and preferred shareholders) and its bondholders (creditors). The firm owes its investors a reasonable return—reasonable by the investors’ standards, not the firm’s. At the same time, the returns paid to the investors have a direct impact on the value of the firm’s investments, as well as the value of the firm itself. Therefore, it is in the firm’s best interests to minimize the cost of the money it receives. It is also in the investors’ best interests for the firm to minimize its costs; the lower the cost of the debt used, the more likely the firm will be in a position to pay the debt on time and in full. Likewise, the lower the cost of the funds used, the higher the present value of the firm’s cash flows, and therefore the higher the intrinsic value of the firm’s stock. So, minimizing the firm’s cost of capital is in the best interests of the firm and its stakeholders.

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  eBook - ePub

  The Essentials of Financial Modeling in Excel

  A Concise Guide to Concepts and Methods

  • Michael Rees(Author)
  • 2023(Publication Date)
  • Wiley

    (Publisher)

  In the simplest (or “reference”) case(s), we assume that the financing mix is only equity and debt and take only the corporate tax rate into account. The other factors are ignored or considered irrelevant. In this case, the overall cost of capital is known as the Weighted Average Cost of Capital (WACC). It reflects the amount of each type of financing (using market values, and assuming that the optimal financing structure is used).

  The WACC can be expressed as:

  The WACC is in principle a pre‐tax figure. However, often a post‐tax figure is required, and is defined as:

  This can also be written as:

  (again, the symbols are self‐explanatory). To avoid confusion, we will refer to the “pre‐tax WACC” and the “post‐tax WACC” where relevant in this text, and to WACC when the concepts discussed apply to both.

  In practice, the WACC is not directly observable, and one may wish to estimate it by building it up from its components, which may have some observable aspects to them (e.g. the cost of debt, equity prices, and taxes). However, when doing so, one cannot simply “fix” a cost of equity and a cost of debt, and then use a weighted average formula to calculate the WACC. This is because the cost of equity changes according to the leverage, as discussed in the next Section.

  16.6 MODIGLIANI‐MILLER AND LEVERAGE ADJUSTMENTS

  An important concept that was developed by Modigliani and Miller (MM) is that – in idealized circumstances (essentially perfect markets with no costs associated with financial distress, and no taxes) – the value of the operations of a business does not depend on the split between debt and equity on the funding side, but rather only on the business operations (i.e. on operational cash flows).

  Therefore, for any debt/equity mix, the pre‐tax WACC is constant. Further, it must equal the cost of equity for an unlevered business (since this is simply the case in which there is no debt in the mix). Since the cost of debt is constant (as debt levels vary), the cost of equity must adjust so that the pre‐tax WACC stays constant. Using the formula in the last section, the cost of unlevered equity is therefore given by:

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  eBook - ePub

  Basic principles of financial management

  • Brümmer LM, Hall JH, Du Toit E(Authors)
  • 2017(Publication Date)
  • Van Schaik Publishers

    (Publisher)

  183

  11

  Valuation and the required rate of return

  Learning outcomes

  After studying this chapter, you should

  • understand the principles of valuation
  • be able to master the basic valuation formula
  • be able to calculate the cost of capital
  • be able to calculate the cost of owners’ equity
  • be able to calculate the cost of preference share capital
  • be able to calculate the cost of long-term debt capital
  • understand the Weighted Average Cost of Capital
  • know how to apply the Weighted Average Cost of Capital in developing an organisation’s capital structure.

  Introduction

  In Chapter 10 , the terms “cost of capital” and “required rate of return” were used frequently. These two terms are often used interchangeably. In one sense, they mean virtually the same thing, yet they can mean different things, depending on the context in which they are being used.

  In this chapter, we shall briefly discuss these concepts because the cost of capital, especially the Weighted Average Cost of Capital (WACC), plays a role in determining the discount rate in the net present value (NPV) method. Provided enough information can be obtained from the financial statements of a prospective debtor or investment project (e.g. the purchase of shares in an organisation), the task of calculating the WACC should be relatively easy. Besides providing a suitable discount rate, the WACC can also indicate whether an organisation is operating profitably or not. This can be done by comparing the organisation’s current rate of return on investment (ROI) with its WACC. For an organisation to be profitable, its ROI must always be greater than its WACC. 184

  Apart from the information already mentioned, the WACC also provides the means for developing an organisation’s capital structure. Refer to the quarter marked Q.1 in LJE Ltd’s Statement of Financial Position in Chapter 4

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  eBook - ePub

  Modern Management in the Global Mining Industry

  • Robin G. Adams, Christopher L. Gilbert, Christopher G. Stobart(Authors)
  • 2019(Publication Date)
  • Emerald Publishing Limited

    (Publisher)

  The estimation of expected returns requires dispassionate judgement with regard to both geological and environmental risks and expected prices. Most major mining companies have come to rely on external price forecasts, typically made by specialised consulting companies. It is my belief that a good consulting company will have the expertise and databases which will allow it to make more accurate forecasts than could be generated internally. However, even if this is not the case, shareholders will value this input, first because it is seen to be independent and second, because the use of external consultants will ensure that all major mining companies are evaluating mining prospects against a common set of criteria.

  The Capital Asset Pricing Model

  Modern business finance theory recognises that the price charged by the market for supplying finance consists of more than simply the nominal interest rate charged on any loans. Investors also supply equity, and are only willing to do so in the expectation of a return in the form of some combination of dividends and capital gains. The standard analytical framework within which these issues are evaluated is known as the capital asset pricing model (CAPM). It rests on two propositions. The first is that the cost of capital is a weighted average of the cost of debt and the cost of equity. This is usually referred to as the Weighted Average Cost of Capital (WACC), which can be expressed as follows:

  WACC = (1−T) × D × p% + E × (100% − p%) where D is the cost of debt per annum; T is the corporate tax rate faced by the company; E is the cost of equity per annum; and p is the proportion of debt in the capital structure. The second proposition relates to the premium that managers should seek over the WACC to reflect the riskiness of the company’s activities.

  The cost of debt is simply the interest rate that a company pays on its long-term bonds. However, since interest is tax deductible, the nominal interest rate must be multiplied by the tax rate to get the lower effective tax rate (e.g. an interest rate of 6% and a tax rate of 30% means an effective rate of 4.2%).

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  Financial Literacy

  • Richard A. Lambert(Author)
  • 2016(Publication Date)
  • Wharton Digital Press

    (Publisher)

  However, for ROA there is another natural benchmark: the rate of return that investors in the marketplace expect to earn. That is, what rate of return do investors expect to be able to achieve on investments of comparable risk? 18 Because the nature of their claims on the profits of the firm differs for debt holders versus shareholders, the riskiness of their claims also differs, and therefore so does the premium for risk they will insist on earning. 19 As a result, we’ll refer to the firm as having a cost of debt capital, a cost of equity capital, and a Weighted Average Cost of Capital (or WACC—pronounced whack!), which is a mixture of the two. In calculating ROA, our measure of investment is the total assets of the firm. Because the assets have been funded in part by debt holders and in part by shareholders, the appropriate benchmark should weight the required rate of return for each group. To illustrate, suppose our assets are funded 50-50 with debt and equity. If we have to pay 8% on our debt and our tax rate is 35%, the after-tax cost of debt is 5.2%. Suppose the cost of capital provided by equity is 12%. (We’ll talk more about this later.) Then the WACC is 0.5(0.052) + 0.5(0.12) = 0.086, or 8.6%. The WACC is the appropriate measure of return to compare to our firm’s realized ROA. So in this case, an ROA of 20% is great! Keep in mind that the WACC will change over time as inflation varies, and it will be different for different firms, and especially for different industries, because their risks are different. It’s also important to remember that the WACC applies to the firm as a whole; it does not necessarily apply to each segment of the firm

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  eBook - ePub

  Company valuation under IFRS - 3rd edition

  Interpreting and forecasting accounts using International Financial Reporting Standards

  • Nick Antill, Kenneth Lee(Authors)
  • 2020(Publication Date)
  • Harriman House

    (Publisher)

  separately. Exhibit 2.11: Capital value decomposition

  WACC and its components – No growth
  Source of capital	Annual receipt (CF)	Discount rate (k)	Capital value (V)	Note
  Debt	25	5%	500	V=CF/k
  Equity	75	15%	500	V=CF/k
  Capital	100	10%	1,000	V=CF/k

  If the value of the assets is unchanged by the shift in financing structure, then that is another way of saying that the Weighted Average Cost of Capital (WACC) does not change as the blend of debt and equity changes. Increasing the gearing has the effect of increasing the cost of a diminishing portion of equity and increasing the portion represented by low-cost debt. The weighted average remains unchanged. Exhibit 2.12 shows a chart of the movements in the cost of equity, the cost of debt, and the Weighted Average Cost of Capital as the gearing increases.

  Exhibit 2.12: Leverage and WACC

  So far, so conventional. This is the point at which the textbooks move on to the talk about tax shelters and the cost of default risk. But let us stop here a moment and explore a point that often gets left out.

  The valuations in exhibit 2.13 are derived by dividing annual cash flow by the discount rate. $100 a year discounted at 10% is worth $1,000. But what if the cash flows are growing? Well, we know how to value a growth perpetuity. So, just as an example, let us take the 50% debt financed example from exhibit 2.11, and assume that the company, instead of not growing, is going to grow at 3% annually. We use the Gordon Growth model to value the cash flow streams independently, and then to value the company using a weighted average cost of capital.

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