In the last primer, I went over using a. A major component in deriving a company's value using a DCF is the . Although many of us on WSO know how to create a WACC in our sleep or have memorized the formula, I know some monkeys still do not fully understand the pieces which make it up, in particular the components of the cost of equity and cost of debt. To all college students, , and new hires, please read and review the attached model to learn the different ways to derive the weighted average cost of capital. I will show how to build a WACC using the build-up method and . This article is meant for monkeys with a little to no understanding of WACC.
A company's assets are financed either through equity or debt. In order to acquire assets (cash, inventory, fixed assets, etc.), you can either sell equity (a stake in your company) or finance it through debt (a loan from the bank). This article will not go in-depth regarding WACC theory, rather, reviewing the models provided will hopefully help college monkeys understand how a WACC is built in the real world.
The WACC formula is as follows:
WACC = E/V *Re + D/V * Rd * (1-Tc)
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
Hopefully after reviewing the attached models, this formula will be more intuitive.
The WACC is made up of the cost of equity and the cost of debt. In both models, these are separated out. The factors which go into the build-up method for the cost of equity (CoE) include the risk-free rate, equity risk premium, size premium, and company specific risk premium. Some models will also include an industry specific risk premium.
Risk-free rates can either be normalized for a period of time or the risk-free rate as of the date of your valuation. Risk-free rates can be found through the Federal Reserve website. Equity risk premiums, size premiums, and industry specific risk premiums are all found in Ibbotson's SBBI Valuation Yearbook, which is updated each year. Company specific risk is determined by the valuation analyst and includes various factors. The combination of these will give you the cost of equity.
The modified CAPM is very similar to the build-up method. The only difference is the need for publicly-traded comparable companies to derive a beta. The median beta of your publicly-traded companies will be used to multiply your equity risk premium (from SBBI Yearbook) and then add the risk-free rate, size premium, company specific risk premium, and industry risk premium to determine the cost of equity.
Cost of debt
Depending on the credit rating of your subject company, you will determine the cost of debt. Typically, the Moody's Baa rate is used as a default (at least for the organizations I have worked for, please correct me if I am wrong). This rate can also be found on the Federal Reserve's website. Due to tax benefits, you will need to multiply the pre-tax cost of debt (Moody's Baa rate as of that date) by 1 minus the subject company's rax rate. The resulting percentage will be the cost of debt.
Capital structures should be determined through the typical company in the industry. This can either be determined through guideline public companies, or other private company databases. The selected percentages will be multiplied by each respective cost, and then combined to determine the weighted average cost of capital.
The next part of the primers will include net working capital analysis, market approach, option pricing models, and more.