What is Capital?

•Money used to start or run a business.
•Where does capital come from?
- Borrowing from banks (debt)
- Owners/investors put their own money in the company (equity)


What is WACC?

•Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted.
•All sources of capital, including common stock, preferred stock, bonds and any other long-term debt, are included in a WACC calculation. A firm’s WACC increases as the beta and rate of return on equity increase, as an increase in WACC denotes a decrease in valuation and an increase in risk.
•Debt and equity are the two components that constitute a company’s capital funding. Lenders and equity holders will expect to receive certain returns on the funds or capital they have provided. Since cost of capital is the return that equity owners (or shareholders) and debt holders will expect, so WACC indicates the return that both kinds of stakeholders (equity owners and lenders) can expect to receive. Put another way, WACC is an investor’s opportunity cost of taking on the risk of investing money in a company.


Variables Needed to Calculate WACC




WACC Example

Sanstreet, Inc. went public by issuing 1 million shares of common stock @ $25 per share. The shares are currently trading at $30 per share. Current risk free rate is 4%, market risk premium is 8% and the company has a beta coefficient of 1.2.

During last year, it issued 50,000 bonds of $1,000 par paying 10% coupon annually maturing in 20 years. The bonds are currently trading at $950.

The tax rate is 30%. Calculate the weighted average cost of capital.


WACC Example

First we need to calculate the proportion of equity and debt in Sanstreet, Inc. capital structure.

Current Market Value of Equity = 1,000,000 × $30 = $30,000,000
Current Market Value of Debt = 50,000 × $950 = $47,500,000
Total Market Value of Debt and Equity = $77,500,000

Weight of Equity = $30,000,000 / $77,500,000 = 38.71%
Weight of Debt = $47,500,000 / $77,500,000 = 61.29%



WACC Example

•Now, we need estimates for cost of equity and after-tax cost of debt.
•
•We can estimate cost of equity using either dividend discount model (DDM) or capital asset pricing model (CAPM).
•
•Cost of equity (DDM) = expected dividend in 1 year /current stock price + growth rate
•Cost of equity (CAPM) = risk free rate + beta coefficient × market risk premium
•
•In the current example, the data available allow us to use only CAPM to calculate cost of equity.
•Cost of Equity = Risk Free Rate + Beta × Market Risk Premium = 4% + 1.2 × 8% = 13.6%
•
•Cost of debt is equal to the yield to maturity of the bonds. With the given data, we can find that yield to maturity is 10.61%.
•
•For inclusion in WACC, we need after-tax cost of debt, which is 7.427% [= 10.61% × (1 − 30%)].


WACC Example



WACC = 38.71% × 13.6% + 61.29% × 7.427% = 9.8166%

















Last modified: Tuesday, August 14, 2018, 8:50 AM