What does WACC represent conceptually? Why do we use it?

I understand, at least on a superficial/calculation level, how to discount cash flows/calculate NPV. But, I am not sure I have a deep enough understanding of the concept behind it. Let me use a simple example of a bond. There are two bonds, one earns 5% and the other 6%, both with par of $1000. After a 5 year maturity period, 5% bond's cash flow sum is ~$1276 and 6% bond's cash flow sum is ~$1338. Finance tells us that we use the discount rate of 6%. If we use a discount rate of 6%, then NPV of 6% is highest and it seems to be the better investment, so long as the two bonds have a similar risk profile. So, just for comparison purposes this makes sense, but is there any deeper reason that I am not seeing here?

And to just ask quickly about WACC, WACC is the theoretical cost of capital. So, why is the cost of capital used to discount cash flows? For NPV calculation of a loan, you are comparing loans to next best alternative investment, but WACC is not being compared to anything. Can anyone answer to these problems? Thanks

 

First of all, that example is a bit flawed in that if a 5% bond and a 6% bond are both yielding 6% (the discount rate you used) then the 5% would be trading at a discount (cost less than the 6%) and the two bonds would have equal NPVs.

To answer your question on WACC, you need to look at it the other way around. You don't compare WACCs, you use WACC to compare cash flows. You determine a company's WACC based on its comparables universe. For similar companies, their WACCs are going to be pretty close. Their equities are going to be closely correlated, they will be in the same lending environment, etc. This is pretty powerful on several dimensions. It provides a benchmark for managers to evaluate investments, investors find undervalued investments, and so on.

It may help to try to put WACC in a more tangible perspective. In the case of evaluating a company using WACC, it's not the "theoretical" cost of capital, it should be the literal cost of capital. Cost of debt is based on how a company has historically borrowed/could go out to the market and borrow. Cost of equity is based on the type of return investors have historically required on that type of investment (forgetting preferred eq. for this explanation). You use WACC to ask "if this company can finance its future cash flows by borrowing at x% and needs to return x% for its equity holders, what do its cash flows imply that it is worth today?"

 

I believe I understand what your saying, but I have one thought, so please tell me if my thinking is wrong here. The reason we use WACC is not because it is the cost of capital, but because this is what other investors expect for their return? Let's say that WACC is 4%, then debt and equity investors expect a 4% return on their capital. If a company is not returning at least 4% in cash flow, then the cost of investment is higher than the return and you, as the potential investor, are losing money. Is this far off the mark or on point?

 

WACC isn't what investors expect for their return, return on equity is.

Look at the equation for WACC.

WACC = (After-tax cost of debt * % debt) + (Cost of Equity * % equity)

You should be able to get a pretty good understanding from that equation alone. But if you can't, the WACC is essentially, on average, how much the company "pays" for every dollar of investment. It's a discount rate WEIGHTED on their capital structure (how much debt they take on, and how much equity they take on).

Companies that take on a less debt than another company usually have a higher WACC, because equity is more expensive (it's riskier, so it costs more). Because they take on so much equity, they have to pay those equity investors a higher % return (as opposed to paying debt investors).

Someone correct me if I'm wrong here, but I believe there are some nuanced cases where companies with extremely high levels of debt may have a higher WACC. Since they have so much leverage, they're seen as very risky, and must pay a higher % return to their debt investors.

 

Is this a RE group? Just curious because otherwise they are in some pretty major financial distress.

Anyway, not going to solve this for you. I'll give you two hints though and it'll take you less than a minute to solve.

1) You can use the normal WACC formula and treat E as 40% of the whole and rE as 15% (average of common and preferred but only because the preferred and common weights are the same). http://lmgtfy.com/?q=wacc 2) This is the better way because it'll always work. http://macabacus.com/valuation/dcf/wacc

Solve it, post it, and I'll tell you if you're right. One last hint, it's a whole number.

 

This is what I came up with can't tell If i'm way off though. WACC = E/V * Re + D/V * Rd * (1 – Tc) The Average rate of raising money

Re = cost of equity Rd = cost of debt E = market value of the firm’s equity D = market value of the firm’s debt V = E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tc = corporate tax rate

WACC: (.6)(.125)(.8) + (.2)(.14)+(.2)(.16) = 1.2%

 
  1. 14% = 30%(1-21%)Kd+70%*18%

Kd= 5.907%

6.

WACC = 50%(1-21%).8%+50%*Ke

Ke is NOT 18%. Why? As you lever up, your Beta increases, increasing your cost of equity (all other input remaining equal).

By doing simply math, we can see Ke is 20.48%.

Hope this helped.

"Come at me, bro"- José de Palafox y Melci
 

Thank you for your replies.

@lasampdoria. The answer is not given, and so the WACC equation has two unknowns, both the Ke and WACC.

How would I go about calculating the new cost of equity without knowing the WACC?

shark-monkey:
Where is this question from?

These questions are from an earlier exam in corporate finance at my school, Sir.

 

Eureka, lol. Think I've got it now, so as leverage increase the risk of equity also goes up and hence the cost of equity.

So if Rs is the cost of levered equity, Ru is the cost of unlevered equity, Rb is the cost of borrowing, tc the corporate tax rate, then

Rs = R0 + (R0-Rb) * B/S (1-tc)

I can use the information from question 5, solve for R0, then use that to calculate the new cost of levered equity and then calculate the average cost of capital. Brilliant! :)

Hold your horses, Wall Street, here I come, lol.

Thank you very much to all of you for helping me.

 
BustedLoser:
Eureka, lol. Think I've got it now, so as leverage increase the risk of equity also goes up and hence the cost of equity.

So if Rs is the cost of levered equity, Ru is the cost of unlevered equity, Rb is the cost of borrowing, tc the corporate tax rate, then

Rs = R0 + (R0-Rb) * B/S (1-tc)

I can use the information from question 5, solve for R0, then use that to calculate the new cost of levered equity and then calculate the average cost of capital. Brilliant! :)

Hold your horses, Wall Street, here I come, lol.

Thank you very much to all of you for helping me.

Anytime BL. You essentially figured this out on your own.

One quick way to remember, is to unlever your Beta, then lever it back up with the new D/V ratio.

If you have any other questions, don't hesitate to post.

"Come at me, bro"- José de Palafox y Melci
 

Does your class have a textbook that you could reference before you upload a picture to the internet and give up? My neck hurts from trying to read that, and if you're quitting on a WACC calculation where they had you all the info you need, start thinking about a career outside of finance.

 

These are very very basic plugin calculations which you could find in your textbook but anyways here's a short summary on how to find the answers: cost of debt - the yield to maturity of the bond can be used in determining the cost of debt, use the bond pricing formula and solve for 'i' cost of preferred shares - cost of preferred stock = dividends per share / current price per share, you have all the numbers cost of equity - capm formula, risk free rate + (beta *market risk premium) apply those number to its respective capital proportion (equity - market cap, debt - don't forget the tax shield, preferred stock) and you should get WACC, this is your discount rate for your cashflows NPV > 0 yes, NPV

 

As above, this is an extremely simple question and you coming here asking for help rather than figuring it out doesn't reflect well on you. That said, answer below:

Debt: calculate the YTM using your financial calculator, this is your pre-tax Kd. Adjust for tax and you have cost of debt. Preferred: Kp = yield Equity: CAPM

Use market values of debt, prefs and common to get %%s for WACC. If you're given any additional information about levered betas, target capital structure etc. then adjust your answer to use industry standard costs and capital structures.

 

What you're trying to do is inherently nonsensical, but if I had to do it, I would use the following method:

  1. Select the appropriate term (1 year, 2, 5, 10, etc.);
  2. Use market rate cost of debt for debt component (corresponding to term);
  3. For equity component, pull the state's/municipalities credit rating and analyze the equity returns in a market of comparable risk (corresponding to the selected term).

For example, if the market in question has a AAA rating, then look at the equity returns of a mature, AAA rated market (i.e., the US/S&P 500). If your municipality is junk status, then calculate the equity returns in a market of comparable risk (i.e., Russia/MICEX).

“Elections are a futures market for stolen property”
 

This is a relevant post, but this isn't really recent research - this is a staple on most corporate finance books.

I'd also say that politicking is what happens when the company does not breakup their WACCs. High risk divisions get favored - their risk-adjusted incompetence is badly calculated and seems like a good thing, the company invests more and more in the risk adjusted incompetents, and soon enough the entire company becomes riskier and the WACC needs to get adjusted anyway. Low risk divisions get screwed and so do the shareholders.

One may argue on regression vs bottom up betas or alternatives but, no matter what is used, riskier divisions must take account of that risk in some quantifiable way, and the effect on WACC (or adjusted cash flows) will be similar.

 

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