Lecture 14: Weighted Average Cost of Capital (WACC)

Steven Golbeck
Northwestern University, Department of Industrial Engineering & Management Sciences

April 27, 2012

Steven Golbeck

Lecture 14: Weighted Average Cost of Capital (WACC)

MARR

How to set the company wide discount rate? Essentially this rate of return should reect the cost involved in raising more money (from banks, bond market, or stock market). We will assume that the mix of funding (the ratio of loan to bonds to stocks) remains the same as that is a dierent discussion. So the question is if we want to raise another million dollars (in the same proportion of loans, stocks, to bonds as the company is doing currently) what rate of return do we need, to pay the creditors back.
for the bank this is merely the interest rate rL ; for the bond holders this is the yield rB ; for the stock holders...well get back to that. Lets just assume that the stock holders want a rate of return rE (stands for return on equity).

Then our company wide discount rate (often called the weighted average cost of capital or WACC or the minimum attractive rate of return MARR) is just the weighted average of rL , rB , and rE . The weights are the fraction of the funding coming from each.
If we have a loan worth 300M, bonds worth 1B, and a market cap worth 5B, then the weights are 0.3/6.3, 1/6.3, and 5/6.3 respectively.

Steven Golbeck

Lecture 14: Weighted Average Cost of Capital (WACC)

Return on Equity What is the return, rE , the stock holders are expecting? One way to estimate rE is to use CAPM (its better than pulling it out of thin air), which we will cover in a few weeks. rE = rf + (rm rf ) We can estimate our companys from historical company, market, and risk-free returns. Complications
1 2

Cannot estimate beta very accurately. We are ignoring various taxes.

In practice you want to include the applicable tax breaks in your calculation of the return we need to provide investors. One famous tax break is the tax break for interest payments. This essentially changes the eective rB and rL .

The only place where we consider riskiness is the riskiness of the entire company when we try to estimate . But we may want to estimate this for individual projects (if the hassle is not too big and the projects are important enough).
This rarely happens (except when this is a billion dollar investment). But sometimes for a big conglomerate, the dierent divisions have dierent discount rates to reect their dierent riskiness.
Steven Golbeck Lecture 14: Weighted Average Cost of Capital (WACC)

Example 6 years ago, our company went public. We sold 10 million shares for $10 each and borrowed $100 million with bonds at 7% interest for 30 years. To undertake a major expansion, we will do this: Sell 1 million shares more for $20 each, the current market price. Borrow $20 million at 7% interest for 30 years. Whats our WACC? First we determine our debt and equity: D = 100m + 20m = 120m E =11 million shares $20 each = 220 million. What is rf ? rf is the risk-free rate - this is the rate that you would get if you invested in something that has no risk. Does this exist? Technically, no. Your bank can go out of business, your country can collapse. What is close? In the US, US treasury bills (backed by the U.S. government, pay out interest after one year or less). The LIBOR, representing the rate at which London Banks lend each other money, is also used.
Steven Golbeck Lecture 14: Weighted Average Cost of Capital (WACC)

Example What is rm ? Expected market return rm : the historical expected return that you will get on a nancial market, such as the S&P 500. rE = rf + (rm rf ) To get rE , need to know , rf , rm . We might want to match rf and rm correctly to our product. If we have a 30-year investment were considering, we might want to compare to the rate on a 30-year risk-free investment, and not a 1 year treasury bill. Why is it rm rf ? The risk-free rate attempts to measure the time value of money. You dont have any risk, but you give up exibility. Youre locking your money into a security for a xed amount of time, and so youre getting paid for that. The market rate represents the value of risk. Youre getting some reward for having a risky investment (you might not make the money back). So what is rm rf ? It is known as the market risk premium or the market premium. The dierence between the market premium and the interest free rate is the value contributed by risk.
Steven Golbeck Lecture 14: Weighted Average Cost of Capital (WACC)

What is ? The term is a number describing the relation of the companys equity returns with those of the nancial market as a whole. R. It measures risk. If you have the market premium, and the risk free rate, you can plot this as a function of beta. rE = rf + (rm rf ) Suppose = 0. Then rE = rf . No matter how the market changes, your equity is completely unaected. If = 1, then rE = rf + rm rf = rm . Your asset moves the same as the market. What happens in the market, so goes your assets rate of return. If = 1, perfectly the opposite of the market. In between: If 0 < < 1, then: rE = rf + (rm rf ) = rf (1 ) + rm Then if the market gets better, your return increases, but less than the market increases. If > 1, then greater risk than the market. The risk can also be great but in a negative direction. Just dening is hard - how can you do it without historical data? Find something close to your investment and t a regression or trend line.
Steven Golbeck Lecture 14: Weighted Average Cost of Capital (WACC)

WACC is hard to describe Figuring out the expected return on bonds itself can be tricky. Have to incorporate things like credit risk sensitivity - is your company a risky credit investment. This itself can be hard to judge. Need to pick the right risk free investments to dene. An extra wrinkle that weve never discussed: Taxes. When you encounter WACC later, you might see it written as W ACC = M VE M VD rE + rD (1 t) M VD + M VE M VD + M VE

Debt is tax free. So if the tax rate is 10%, then the contribution of debt is: M VD (rD 0.9) M VD + M VE Debt contributes less to WACC due to tax deductions. You can deduct the interest payments on debt issued, so this lowers the cost of capital.

Steven Golbeck

Lecture 14: Weighted Average Cost of Capital (WACC)

Find the WACC. Assume that bank loans and bonds (both debt) are untaxed, and the tax rate is 40%. Type Bank Loan Bonds Stock Market Value 20m 20m 60m Rate of Return 9% 7% 11% Returns Last Year 1.8m 1.4m 6.6m

W ACC

M VL M VD rL (1 t) + rD (1 t) M VE + M VD + M VL M VE + M VD + M VL M VE rE + M VE + M VD + M VL

We have that: M VL = 20, M VD = 20, and M VE = 60. W ACC = 20 20 60 0.09 (1 0.4) + 0.07 (1 0.4) + 0.11) = 0.0852 100 100 100

Notice that the total returns from last year were $9.8m relative to $100m in total capital, so the company had a total return of 9.8%, which is larger than W ACC = 8.52%. The company is protable.
Steven Golbeck Lecture 14: Weighted Average Cost of Capital (WACC)

Why not issue all debt? Debt is tax deductable, so why not take advantage of this? The more debt you issue, the more leveraged the company becomes. A small percentage loss can wipe out all of the equity in the company, making it insolvent (it can no longer pay back its debt). Leverage also increases the cost of debt, rD . Eventually any gains from tax deductions are lost due to higher interest rates. Why is WACC useful? Can be used by a company to decide whether to take an investment. If the investment does not return at least as much as our borrowing/capital costs, then we should not make the investment. The WACC can represent the Minimum Acceptable Rate of Return (MARR) that a project/investment must earn for us to consider it.
If there is a rejected projected with an IRR>WACC, then this is the MARR as any feasible project we consider must at least have a higher return.

You can also think of WACC as the companys discount rate, representing its cost of nancing.

Steven Golbeck

Lecture 14: Weighted Average Cost of Capital (WACC)