Module 1

Weighted Average Cost of

Capital (WACC)

Introduction
Decision Process
Importance of WACC
WACC and Capital Budgeting
WACC Formula
Capital Structure
5-1
Introduction

Cost of obtaining funds;

Primarily for investing activities.

5-2
Decision Process

Personal Finance: Financing, Investing,

Operating;
Corporate Finance:
> Investing (Look);
> Financing (WACC determination);
> Investing (Accept?);
> Financing (Raise funds);
Cash
> Investing (Expenditure); Flows
> Operating (Day-to-day)

5-3
Importance (Use) of WACC

1. Capital Budgeting (NPV,IRR);

2. Valuation of Stocks (CVM);
3. Valuation for Mergers/Acquisitions (DCF).

5-4
 WACC and Capital Budgeting

A = D + E;
Rate of return of A vs. Cost of Capital
(WACC) of D + E; this is IRR;
Benefits (PV of CFs using Cost of Capital, or
WACC, as discount rate) vs Cost investment
(in A); this is NPV.

5-5
 WACC Formula
WACC
= [Wd x rd (1-tax rate)] + (Wp x rp) + (Wc x rs)
= [(D/V) x rd (1- tax rate)] + [(C/V) x rs] + [(P/V) x rp]
Wd = weight of debt; Wp = weight of PS; Wc = weight of
CS
D = Value(MV) of debt; P = Value(MV) of PS;
C = Value (MV) of CS
Rd = return on debt; interest rate;
rd(1-tax rate) = after-tax cost of debt
rp = return or cost of preferred stock;
rs = return or cost of equity; RE (internal equity);
re = return or cost of new CS (external equity)
5-6
WACC Formula

Sample illustration
Given:
D = P15M, C = P25M, P = P10M; rd = 5%, rp = 10%,
rs = 15%, tax rate = 30%
Solution:
= 30% x 5%(1-30%)+ 20%x10% + 50% x 15%
= 10.55%

5-7
 Capital Structure

Proportion of debt, PS and CS;

Optimal Capital Structure (OCS): maximize shareholder
wealth (maximize stock price) and minimize WACC;
Basis: Using DDM, higher stock price, lower rs,
lower WACC; Using CVM, lower WACC, higher MV of Firm,
higher MV of Equity, higher stock price;
Current capital structure: based on BS; same with OCS? can
be the OCS?

5-8
 Capital Structure
Hierarchy of amounts: 1) Target; 2) Market Value (Equity =
Shares x Stock Price; Debt = PV of CFs using DCF);
3) Book Value (PS = Par Value; CS = Par Value, APIC/Share
premium, RE; Debt = LT debt in the books
Inclusion: LT sources; investor supplied funds;
Exclusion: CL such as AP and accruals (not investor
supplied);
Other CL: ST interest-bearing note and current portion of LT
debt (included accdg to Brigham);
ST debt used to finance LT investment, ST debt rolled
over and becomes permanent (included accdg to Brealy);
Other CL (excluded accdg to Gitman; CL in general are
excluded) 5-9
 Illustration

Question: Theory 10-3, page 359;

Answer: Use 1st - target capital structure, 2nd MVs, 3rd
BVs
Question: Problem 10-9, page 360;
Solution:
> D = P1,152, C = 576 shares x P4 = P2,304
> V = P1,152 + P2,304 = P3,456
> Wd = P1,152/P3,456 = 33.33%;
Wc = P2,304/P3,456 = 66.67%
> WACC = [13% x (1-40%) x 33.33%]
+ (16% x 66.67%)
= 13.27%
5-10