Weighted average cost of

capital
Timothy A. Thompson
Executive Masters Program

What is the WACC?

WACC = (D/D+E) rd (1-Tc) + (E/D+E) reL
D/D+E and E/D+E are capital structure weights
evaluated at market value, based on the firms target

capital structure

Tc is the firms marginal tax bracket, but the effective tax

rate is often used as estimate
rd is the cost of debt based on the risk of the debt (which
depends on the debt ratio)
reL is the required rate of return on equity (I.e. the cost
of equity)
the cost of equity depends on the business risk of the

assets

and on the debt ratio

Why the WACC?

Measures the returns demanded by all
providers of capital
Investments must offer this return to be
worth using the capital providers money

As an opportunity cost
The rate of return investors could earn
elsewhere on projects with the same risk
and capital structure

WACC incorporates debt tax shields

The (1-T) term incorporates the fact that
debt returns are tax deductible
Discounting project cash flows at WACC is an
alternative to adding in the value of tax
shields (ala AHP)
Key assumption: constant D/D+E ratio is
reasonable as a target capital structure

Risk and return

It is reasonable to believe that the

higher the risk of an investment, the
higher its required return. But
What is risk, and
What is the relation between risk and
required return?

Capital Asset Pricing Model

The result will be that risk of investment
(stock j) is measured by its beta ( j)
Any risky security has a required return given
by:
the risk free rate of return, rf, plus
a risk premium which is proportional to its beta
risk

Equation: rj = rf + j (avg. risk

prem.)

Diversification: roulette wheel

Fair roulette wheel
40 slots, 20 black, 20 red (no house slots)
probability of red = 50%

Bet $10,000 on red, one spin

risky?
50% prob of 100% loss

Bet $1 per spin on 10,000 spins: as risky?

Why is it less risky?

Diversification reduces risk

Investors dont hold only one stock
Smart investors hold diversified portfolios
Why doesnt risk go to zero as in the roulette
wheel?
Because stocks are correlated with each other, with the
market as a whole
This is risk you can not diversify away
For risk you must bear, you demand a premium!

What measures non-diversifiable

risk?
Beta

Covariance measures the degree to which two

things move together on average
The more a stock moves up and down with the
market, the more non-diversifiable risk it has
How much risk is in the market portfolio
itself?
The variance of the market
Beta = Covariance of stock with
market/Variance of the market

What is the beta of the market?

Beta of market portfolio is one
Covariance of market with itself/Variance of
market
Covariance of anything with itself is its own
variance

The market risk premium

rm - rf is the risk premium on the market, so it
is the risk premium for a beta of one

Back to the equation

CAPM
rj = rf + j (rm - rf)
assets with betas less than one demand
lower returns than rm
assets with betas greater than one demand
higher returns than rm

How do you apply CAPM?

Common assumption: discounting
future, long term cash flows
so, you want a long term discount rate (forward
looking if possible)
rf is long term government bond rate (forward
looking, I.e., current long term T bond rate)
rm - rf is expected excess return on a very
diversified portfolio of stocks (S&P500?) over long
term government bonds (forward looking not
available, so often use historical average)

How do you estimate beta?

Many services calculate beta estimates
for stocks (some bonds)
Value Line, investment banks

The beta is a statistical estimate

Slope coefficient of a linear regression of the
stocks returns against the proxy for the market
portfolios returns

A stocks beta is a levered beta

Based on the debt ratio it has now

Estimating Charles Schwab beta

Schwab
Returns

Schwab's returns vs. Market returns

-0.10

-0.05

0.4
0.2
0
-0.20.00
-0.4

0.05

Returns on Market

0.10

Regression for Charles Schwab

SUMMARY OUTPUT

Charles Schwab

Regression Statistics
Multiple R

0.494088888

R Square

0.24412383

Adjusted R Square

0.231091482

Standard Error

0.100953718

Observations

60

ANOVA
df
Regression

SS

MS

0.190911525

0.190912

Residual

58

0.591115881

0.010192

Total

59

0.782027406

Coefficients
Intercept
Slope on market

Standard Error

t Stat

Significance F

18.73215

P-value

6.02E-05

Lower 95%

Upper 95%

0.006291272

0.014464831

0.434936

0.665223

-0.02266

0.035246

2.30

0.53

4.33

0.00

1.23

3.36

Corporate WACC vs. Project WACC

The corporate WACC is not necessarily the
cost of capital for a project within the firm:
The systematic risk of the project could differ from
the average systematic risk of the firms projects
The target capital structure for the project
(thought of as a mini-firm) could differ from the
corporate target capital structure

Project-beta
Adjusted
Cost of capital

Expected
Rates
Of
Return
Y

Company-wide
WACC

Avg. company
Project beta

Project Beta

How do you estimate the beta of

a project or division?
Peer method

Collect a sample of publicly traded firms which are

essentially like (you think they face the same
systematic risk) the project or division being
valued
Estimate (or look them up) the peer companies
equity betas
Assuming they face the same business risk, not
the same financial risk (I.e., different capital
structures)

Equity risk
Equity beta risk has two sources:
Business risk (the risk of the asset cash
flows)
which would equal the equity risk if the
business were unlevered (I.e., if it had no debt)

Financial risk
The magnification of the business risk from the
perspective of the equityholders because of the
presence of debt in the capital structure.

Unlever the peer betas

Peers have same business risk as
project
so back out the financial risk How?
First, estimate reL for peers using CAPM
Then use the unlevering formula:
reU = [reL + (1-T)(D/E)(rd)]/[1 + (1-T)(D/E)]
For this formula, you technically need the peers
costs of debt and marginal tax rates (for our
assignment, assume the same as Marriotts)

Average the reUs

These are now estimates of required returns
for business risk only!
Average the reUs
This is your projects reU

The WACC needs reL

You are using WACC to value the
project or division
How do you get reL for the WACC?
Relevering formula:
reL = reU + (1-T)(D/E)(reU - rd)

Plug in your WACC

Your reL is now ready for your WACC
Estimate Tc, the capital structure
weights and rd and youre ready to go!
Look at the lodging WACC
Assignment: Bring back a restaurant
division WACC!

Extra credit
For extra credit, bring back a contract
services division WACC
There are no peers given for contract
services
But you can estimate WACC, reu, reL, etc.
for Marriott as a whole!