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Video 31 (Topic 6.5): The Weighted Average Cost of Capital (WACC)

Video 31 (Topic 6.5): The Weighted Average Cost of Capital (WACC). FIN 614: Financial Management Larry Schrenk, Instructor. Topics. Determining the Weights A Complete Example Using WACC for Valuing… Internal Divisions Projects. Weighting the Sources of Capital.

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Video 31 (Topic 6.5): The Weighted Average Cost of Capital (WACC)

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  1. Video 31 (Topic 6.5):The Weighted Average Cost of Capital (WACC) FIN 614: Financial Management Larry Schrenk, Instructor

  2. Topics • Determining the Weights • A Complete Example • Using WACC for Valuing… • Internal Divisions • Projects

  3. Weighting the Sources of Capital • Weights represent the percentage raised by each source of financing:

  4. Weighting Objectives • Two Possible Goals: • Firm as Currently Financed • WACC as Discount Rate for Project • Decisions • Firm versus Project Weights • Book versus Market • Past versus Future • Actual versus Target

  5. Factors Influencing WACC • Uncontrollable Factors: • Market Conditions, especially Interest Rates • Market Risk Premium • Tax Rate • Controllable Factors: • Capital Structure Policy • Dividend Policy • Investment Policy • Firms with riskier projects generally have a higher cost of equity

  6. WACC Example Investment Amounts Common Stock = $50,000 Bonds = $25,000 Preferred Shares = $25,000 Bond Price = $990 Coupon Rate = 8% Period = Semiannual Maturity = 25 Years Par Value = $1,000 Preferred Stock Price = $85 Dividend = $8 Common Stock Risk-Free Rate (rf) = 5% Return on Market (rM) = 12% Beta (b) = 1.1 Corporate Tax Rate tc= 35%

  7. WACC Example Overview • Calculate Weights, wd, wp, ws • Calculate Cost of Equity Capital, rs, using CAPM. • Calculate Cost of Preferred Capital, rs, using Market Implied Discount Rate • Calculate Cost of Debt Capital, rd, using YTM. • Calculate WACC.

  8. WACC Example: Weights

  9. WACC Example: Cost of Debt Price = $990 Coupon Rate = 8% Period = Semiannual Maturity = 25 Years Par Value = $1,000 Yield to Maturity (YTM) N = 50; I% = 8.09%; PV = -990; PMT = -40; FV = -1,000; P/Y = 2

  10. WACC Example: Cost of Preferred Stock Price = $85 Dividend = $8 Implied Discount Rate

  11. WACC Example: Cost of Common Stock rf = 5% rM = 12% b = 1.1 CAPM

  12. WACC Example: Result • wd = 0.25; wp = 0.25; ws = 0.50 • rd = 8.09% • rp = 9.41% • rs = 12.70% • tc = 35%

  13. Firm WACC and its Divisions • Composite WACC reflects the risk of an average project undertaken by the firm. • Different divisions may have different risks. • The division’s WACC should be adjusted to reflect the division’s risk and capital structure.

  14. The Risk-Adjusted Divisional Cost of Capital • Estimate the cost of capital as if division were a stand-alone firm. • Estimating the division’s beta, cost of debt, and capital structure.

  15. Pure Play Method • Find several publicly traded companies exclusively in division’s or project’s business. • Use average of their betas as proxy for project’s beta. • Hard to find such companies.

  16. Accounting Beta Method • Regression between project’s ROA and S&P Index ROA. • Accounting betas are correlated (0.5 – 0.6) with market betas. • Problem: Data on new projects

  17. Divisional Cost of Capital Using CAPM • Target Debt Ratio = 10% • rd = 12% • rrf= 5.6% • tc = 40% • bdiv= 1.7 • Market Risk Premium = 6%

  18. Division Required Return on Equity: rs = rrf+ bdiv(rM– rrf) rs= 5.6% + 1.7(6%) = 15.8%. WACCdiv = wd rd(1 – tc) + wsrs = 0.1(12%)(0.6) + 0.9(15.8%) = 14.94% Divisional Cost of Capital Using CAPM

  19. Division WACC vs. Firm WACC • Division WACC = 14.9% versus company WACC = 10.4% • ‘Typical’ projects within this division would be accepted if their returns are above 14.9%.

  20. The Risk and Financing of a Project • If project has same financing and risk as the existing business or assets of the firm, use WACC as our discount rate • If the new project has very different financing or risk from existing business, • WACC must be adjusted (if possible), or • Use alternate method to find discount rate

  21. Misusing WACC for All Projects: Example • What would happen if we use the WACC for all projects regardless of risk? • Assume the WACC = 15% Project Required Return Expected Return A 20% 17% B 15% 18% C 10% 12%

  22. Using One WACC for All Projects • You tend to favor more risky projects • Mistakenly reject project C and take project A • In making such mistakes, the firm becomes more and more risky.

  23. Consider the Project Financing and Risk • If the project is more (less) risky than the firm, use a discount rate greater (less) than the WACC • If the project has different financing than the firm, adjust the weights • IMPORTANT: If project weights are significantly different than the firm’s, then this may change required rates of return.

  24. Video 31 (Topic 6.5):The Weighted Average Cost of Capital (WACC) FIN 614: Financial Management Larry Schrenk, Instructor

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