Valuation Primer - Part 3 - WACC

valuationGURU's picture
Rank: King Kong | 1,111

In the last primer, I went over using a DCF. A major component in deriving a company's value using a DCF is the WACC. 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, interns, 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 CAPM. 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)

Where:
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.

Build-up method
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.

Modified CAPM
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 Structure
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.

AttachmentSize
Office spreadsheet icon WACC - model.xls159.5 KB

Comments (193)

Aug 15, 2012

Thanks, man!

Aug 15, 2012

yucky font

Aug 15, 2012
focus:

yucky font

haha I knew I was going to get a comment on that. Feel free to change fonts.

Aug 15, 2012
valuationGURU:
focus:

yucky font

haha I knew I was going to get a comment on that. Feel free to change fonts.

Thanks valuationGURU - great stuff.

Aug 15, 2012

What no Modigliani-Miller theorem??

Aug 15, 2012

Wanna know how I decide what WACC to use? I scratch my head for two seconds, then use 10% for my base case and 15% for my low case.

No one on the buyside spends time thinking about "WACC" ... please. Just another one of those dumb academic concepts.

Aug 15, 2012

Is it horrible to go to bloomberg and take the average weighted costs for pref eq, eq, debt and solve that way?

Aug 15, 2012
Mel Clark:

Is it horrible to go to bloomberg and take the average weighted costs for pref eq, eq, debt and solve that way?

Never heard of that done in a professional setting but I could be wrong. Anyone else know?

Aug 15, 2012
Mel Clark:

Is it horrible to go to bloomberg and take the average weighted costs for pref eq, eq, debt and solve that way?

I would only use Bloomberg to verify and spot-check your numbers. They have a tendency to be outdated and wrong. If you have a DCM team it might be beneficial to just give them a call and try to work out the equity yourself...

Really solid post valuationGURU. Looking forward to more in this series.

Aug 15, 2012

Holy s.hit, cost of capital 18%? Is that some small-cap pharmaceutical company, lol? (not srs). Nice blog post. What do you have next in mind?

The difference between successful people and others is largely a habit - a controlled habit of doing every task better, faster and more efficiently.

Aug 15, 2012
mhurricane:

Holy s.hit, cost of capital 18%? Is that some small-cap pharmaceutical company, lol? (not srs). Nice blog post. What do you have next in mind?

Net working capital analysis, market approach, option pricing models. Just depends on how much time I have after work this next week. Any suggestions besides the three?

Aug 16, 2012

a primer this is. risk free rate itself alone is worth a 10 page discussion let along equity risk premium and all those other junk.

but i digress. academia is very different than irl. dcf in real life is more like your analyst/md setting the price target and then have you fiddle around the model to make it fit with numbers that makes sense.

Aug 16, 2012
vitaminc:

but i digress. academia is very different than irl. dcf in real life is more like your analyst/md setting the price target and then have you fiddle around the model to make it fit with numbers that makes sense.

Sure ... when you're a sell side pitch monkey.

Aug 16, 2012
NewGuy:
vitaminc:

but i digress. academia is very different than irl. dcf in real life is more like your analyst/md setting the price target and then have you fiddle around the model to make it fit with numbers that makes sense.

Sure ... when you're a sell side pitch monkey.

Did your PM ever strike down a stock pitch just because its WACC doesn't make sense?

Not sure on the PE side, but do people actually talk about WACC during negotiations?

Aug 16, 2012

I'm having problems coming up with a WACC ,I feel like its way to low, I keep getting around 7%. Can someone tell me what I'm doing wrong?I used a risk free rate of 2% which is higher than the yield on the 10 year, which is what you are supposed to use. The company has a beta of 0.34, I didn't unlever and relever it as the company has no debt and the only other publicly traded comparable also has no debt so i didn't think it was necessary. I used a risk premium of 15% which I feel is super high, considering I was under the impression that 6%-7% was the norm. Should I just leave it or what?

Aug 16, 2012

The WACC is the discount rate, not the growth rate. Different companies should be using different discount rates, which is why you have the WACC, which accounts for the cost of equity and cost of debt of the company.

Aug 16, 2012

WACC is the cost of debt and cost of equity for each company. Say you're using DCF to get the present value of a project that your company is planning on taking on. You would use WACC to discount the future cash flows (I hope you understand the time value of money) if you were raising capital (issuing debt/equity) to finance the initial cash outflow.

Assets = something that you will get future benefit (revenue) from. Liabilities/Equity = money raised to finance those assets. So when you need to get the PV of your future cash flows (EBIT +/- working capital changes) it only makes sense to discount using WACC because that is the cost of capital needed to fund your assets which in turn provide you with revenue.

Aug 16, 2012

you must be an arts major

    • 1
Aug 16, 2012

WACC measures the risk of allocating capital to the company given it's riskiness relative to it's peers.

Aug 16, 2012

wow, what a monkey

Aug 16, 2012

lol

Aug 16, 2012

Easy with ridiculing the questions like this. I mean, I understand "I-Banking Bulletin" might not be the appropriate place to ask fundamental finance questions like this, but there really isn't other WSO forum that people participate in.
Should encourage new monkeys to ask questions and learn! I know I learned a lot by asking stupid questions.

    • 1
Aug 16, 2012
Vectors225:

Easy with ridiculing the questions like this. I mean, I understand "I-Banking Bulletin" might not be the appropriate place to ask fundamental finance questions like this, but there really isn't other WSO forum that people participate in.
Should encourage new monkeys to ask questions and learn! I know I learned a lot by asking stupid questions.

What a fucking idiot

Aug 16, 2012
Vectors225:

Easy with ridiculing the questions like this. I mean, I understand "I-Banking Bulletin" might not be the appropriate place to ask fundamental finance questions like this, but there really isn't other WSO forum that people participate in.
Should encourage new monkeys to ask questions and learn! I know I learned a lot by asking stupid questions.

boo friggin hoo

Aug 16, 2012

WACC = cost of capital

Aug 16, 2012

i.e. the rate that a company is expected to pay on average to all its security holders to finance its assets

Aug 16, 2012

The inflation rate is a rise in the general level of prices of goods and services in an economy over a period of time

Aug 16, 2012

Great contribution to an old post that was fully answered.

Aug 16, 2012

Waiting for the Swagon comment about WACC being swag related and that OP needs to Discount his Swag Flow.

Walk me through a DCF

EBIT
less Taxes
plus/less non cash expenses/charges
less capex

= FCF

Discount these by the WACC

Calculate the Terminal Value either exit EBITDA multiple or terminal growth Rate and discount this by the WACC

WACC is used for discounting the value of the cash based on risk/cost of a company to generate the cash. Inflation is just the number you use for getting a terminal value. You need to discount it by the WACC.

Aug 16, 2012

As mentioned above, wacc is used to discount your fcfs. The terminal value would be fcf/(wacc - g). This is basically just a converging geometric series because you are growing your fcf at the same ratio in perpetuity. Your terminal growth rate is a long term rate so intuitively it would be something close to the rate of inflation or national gdp growth rate. There are also other caveats to remember tho.

Aug 16, 2012

The cost of debt would be the average interest rate that the company is paying for its debt.
Why would you use the 10year treasury rate? That's a totally different thing and is used in the CAPM calculation.

Aug 16, 2012

If the company has outstanding debt use the coupon rate on the paper for you cost of Debt. Otherwise, use relative valuation and get a spread over risk free. Hope this helps

Aug 16, 2012

Normally you would use a tool like bloomberg to find out what the company's debt is trading at or what similar company's debt with same terms is trading at. Then you would do the WEIGHTED average of the interest.

If you don't have info on the market price, in a normal economic environment (today is normal, 2008 was not) you look at historical interest rate (coupon rate) because the market price won't be too different. Then do the weighted average again. It won't be precise but a good ballpark.

Do what you want not what you can!

Aug 16, 2012

there are a couple directions you can go. most reasonable and defendable is to use the predetermined debt agreement it has, maybe they trade their debt on the market, bloomberg/capital iq may have a comparable company cost of debt. Or you can find comparables with a similar debt rating. Or you can use a risk free rate (like a bond yield) but you will have to apply some judgement in adding/considering a premium based on specific company risk, industry and size factors.

happy valuating!

Aug 16, 2012

whatever spread you use to the risk free, the risk free instrument you pick should match the maturity of the bonds in general.

Aug 16, 2012

It often helps to do a keyword search of the 10-k for "weighted average" which will often land you at their borrowings schedule with a reporting of the company's "weighted average cost of debt". Technically the right rate to use is what you expect them to issue debt at in the future (on a go-forward basis), but usually the weighted avg current rate is the best proxy for this.

Aug 16, 2012

Dig in to Bloomberg more. :)

Aug 16, 2012

If you want a really bare bones way to get cost of debt, you could find the bond rating for the company and then just use the market average for that rating. For instance, the 10 yr AA corp rate is around 3.25 and then 20 yr AA corp is right about 4.0 so you could say that the cost of debt for a company with AA bonds, like Google, is probably around 3.5%.

That said, I would advise you to go back later and weight the debt and calculate a more trustworthy value.

Aug 16, 2012

My initial thought, someone correct me if I'm wrong:

These would typically be high-growth companies, so the increase in the discount rate is offset by higher growth in FCF, so it doesn't necessarily lead to a lower valuation and lower P/E.

Aug 16, 2012

I agree with the above explanation. Some more thoughts:
- the explanation is true based in industry clusters and more true for tech companies
- in clusters such as cleantech eg. wind farms etc, P/E low, WACC intrinsically high, but is made artificially low by regulatory means to enable them to raise debt
- with respect to banks - it will depend upon the particular sector of banking as well as what sort of businesses the bank is diversified into. Conventional banks tend to have lower P/E as well as lower WACC due to steady nature of business as well as strong depository bases
- However banks in S&T and IB, which ideally should have much higher WACC's, tend to couple it with some lower risk businesses to lower market risk to effectively lower WACC. One of the reasons most pure M&A advisory companies are not public, and the emphasis to build up the balance sheet whenever they have the capital to do it.

Aug 16, 2012

.

Aug 16, 2012

All else being equal, and just by looking at the respective formulas:

A higher WACC means a higher cost of equity.
A higher cost of equity lowers intrinsic equity value.
A lower intrinsic equity value results in lower stock price (if the market is efficient).
A lower stock price means a lower P/E.

Aug 16, 2012

Your WACC components would likely include a country risk premium so a simple fx conversion based on spot and forward rates would likely be sufficient depending on the type of analysis you were doing.

Aug 16, 2012

junkbondswap, so what you're saying is use the forward rates to convert the LCU to USD before discounting?

Aug 16, 2012

Use foreign risk free rate and market risk premium

Aug 16, 2012

Okay, those are two different answers...which one is "right" or at least "conventional?"

Aug 16, 2012

Bump. Silver bananas to whoever can help.

Aug 16, 2012

Ev = FCF / (WACc - g) is just the perpetuity growth formula for valuing a business, often used for getting terminal value at the end of a DCF. They are just substituting that for EV. But you need: steady growth, and a stable cost of cap for that to really work, which rarely happens in practice.

    • 1
Aug 16, 2012

Oh, danm can't believe I missed that. Thanks.

    • 1
Aug 16, 2012

jankynoname already answered it, but just for your future reference, you should take a look at valuation by McKinsey for the theoretical derivation of a lot of valuation concepts (especially if you're more math oriented than most banking monkeys).

Aug 16, 2012

Well Charlie says, when explaining the CAPM that we multiply the Beta by the 'market risk premium less the risk free rate.' I'm sure the risk premium itself takes into account how much the equity return is above the risk free rate. Not trying to be obnoxious but don't want people getting confused. Or am I myself??

Aug 16, 2012

It's not the market risk premium minus the risk free rate that's multiplied by beta, it's the market rate of return minus the risk free rate (this difference is your market risk premium).

Aug 16, 2012
Mojito:

How to calculate the market value of debt in WACC? I'm doing a DCF analysis for Amazon and cannot find out the mkt. value of the firm's debt. A detailed instruction would be highly appreciated!

For a DCF you're usually find with using just the book value of the debt.

If you really want to get nitty picky, you can treat the firm's debt as a hypothetical coupon bond and calculate its market value the same way you would calculate a coupon bond

Aug 16, 2012

You could also do a sensitivity analysis with a range of WACC's so if you aren't spot on with your Debt calc you can still have a good model

Aug 16, 2012

Probably fair to assume Amazon's debt trades around par. The market value vs book value argument comes into play when things trade outside of maybe 90 or 110.

Aug 16, 2012

should upload the spreadsheet for people to put in their two cents. cheers.

Aug 16, 2012

If it is investment grade (Amazon is), use the interest bearing debt on the balance sheet.

The difference between successful people and others is largely a habit - a controlled habit of doing every task better, faster and more efficiently.

Aug 16, 2012

Good question. I'm not 100% sure, but I found this, which might help.
http://www.keyvaluedata.com/pdf/articleofinterest/...

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Aug 16, 2012

Great link, this helped clarify things for me. Thanks!

Aug 16, 2012

BUMP

Aug 16, 2012

BUMP

Aug 16, 2012

delete

You know you've been working too hard when you stop dreaming about bottles of champagne and hordes of naked women, and start dreaming about conditional formatting and circular references.

Aug 16, 2012

I think this is a very poorly worded question.

From my experience on the job, this definitely something we consider when sensitizing a synergized DCF value. Say you have the standalone value of the entity. You can layer on revenue (if applicable) and cost synergies to get a "synergized" DCF value. You can take that one step further by illustratively looking at the target "In [Acquiror's] Hands" by doing a few more things. For instance, say the target's standalone WACC is 10% but the acquiror's WACC is around 8%. You could show the incremental increase in value by lowering the WACC by that 2%. This effectively gets you to a synergized DCF value at the acquirer's discount rate. On a side note, if the target is currently unprofitable or has a NOLs balance that has not been fully utilized, another adjustment to this "In [Acquiror's] Hands" you should make is related to the Section 382 limitation, which would effectively reduce the NPV of the target's NOLs balance.

Aug 16, 2012

If the question means what I think it does....which is when would you discount using the acquiring company's WACC instead of the target's...

Seconded with not being a big fan of the question. In practice M&A modeling is going to require that you compute a new WACC derived from merging both company's debt structures as well as the equity components into a single entity and recalculating based off of your new cost of equity and cost of WACC.

If the asker really means "When is modeling with the acquiring company's existing WACC acceptable" it's a pretty narrow set of circumstances for a traditional M&A model. You'd need a company that has no debt, and will have no publicly traded shares post-acquisition.

Aug 16, 2012

The original and best work on size premium was by Fama and French in their two groundbreaking papers: "Common risk factors in the returns on stocks and bonds" and "The Cross-Section of Expected Stock Returns" both of which can be found through Google Scholar. Take the methodology they used on the U.S. CRSP index and apply it to your own local market index. Also, here's paper by two researchers who applied the Fama French methods to calculate the size premium of the New Zealand market.

Aug 16, 2012

7.5 to 9 is normal based on current interest rates.

There's no way you could do it right and get a wacc of 3% though. The 10 yr risk free rate is 3%.

Here's a list of average WACC's by industry type, courtesy of Damodaran

http://www.stern.nyu.edu/~adamodar/pc/datasets/wacc.xls

Aug 16, 2012

thanks. I forgot to specify I was doing analysis of a British company where 10y yield is around 2.7% and yes, it's not 3% it's 4.5%...but it still seems too low for me and unrealistic

Aug 16, 2012

I wouldn't use current 10yr rates for risk-free. Use something like a 30 year average of 10 year rates, which should get you to about 4% RFR. Assuming you're doing a valuation for some sort of longer investment horizon, you want to bake in some mean reversion in rates. FWIW I'm usually getting 8-10% WACCs for most companies (U.S.).

    • 1
Aug 16, 2012

Take the cost of debt add 200-300bps and there is your WACC

Aug 16, 2012

Your RFR or ERP is way off if you are getting 3%. Also I assume you are valuing the equity piece of a firm (Stock) so you should be using the required return on equity, not the firms WACC. Unless your modeling EV (FCFF) in which case you would use firm WACC. If you are modeling really small or international firms I would recommend using a build-up method to derive cost of capital. Damodaran puts out free country risk premia info. Hope this helps you become a baby Buffet.

Aug 16, 2012

Depends on quite a few things, but I would guess it's either due to a difference in beta, equity risk premium, or both.

For example, did you use 5-year beta, 3-year beta, 1-year beta? these could all have different value - Microsoft's beta ranged between 0.80 and 1.20 over a 5-year period. There are many factors that could drive beta variance over different time horizons.

Equity risk premium could be historical (with varying time periods) or current, and even then it depends what you define as risk-free (10-year vs. 30-year).

It may also be the cost of debt you use, assuming debt is a large part of the capital structure.

As you can see, WACC and CAPM have a lot of assumptions and sometimes it's "to each their own." A lot of analysts I know use a set discount rate (e.g. 10%) for the market or specific discount rates for certain industries.

Aug 16, 2012

The latest point of the above is the one take away here. I'd say 95% of research reports I've seen use set buckets and if need be just sensitize it (i.e. 6, 8 and 10% d.r.). Technically speaking, WACC is different than discount rate, as the discount rate it dependent upon hurdle rates and be simply changed around.

To be more helpful, a couple thoughts on your WACC calculation.

- the beta might be run against a different index (i.e. MSCI World Index as opposed to S&P500 if it is a global company)
- 4.5% latest offering - check the YTW of the latest offering. If the prices have gone down, the YTW will be higher than the coupon. Also check to see there aren't a number of other issues / terms loans making with higher rates
- debt / capital should be used for WACC calc, not debt / equity
- typically a target debt / capital is used for this instead of current levels as discount rate is forward looking in nature. I typically see 30-40%

Aug 16, 2012

Both posters above hit the nail on the head.

Aug 16, 2012

Echoing everything above on the equity side. And I would definitely be wary of using the yield of the latest debt offering, especially with movements in the debt markets. I.e. A HY company with a yield of 6% could be trading below par due to current market conditions and will need a hurdle of closer to 8%. And I would also think about the YTW and if it's callable/puttable as well as where it is on the debt structure. (Sr. Secured, unsecured, etc...

Aug 16, 2012

Weighted average cost of capital (WACC) is the average after-tax cost of a company's various capital sources, including common stock, preferred stock, bonds and any other long-term debt. There are good video tutorials which are short & effective I came across in Online Finance Courses | BlueBook Academy Maybe you too could check them out. And CAPM is : A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

Jan 19, 2017

~

Aug 16, 2012
verzen:

The "pros" don't waste their time calculating the perfect WACC. A sell-side analyst I spoke to just says that if he thinks the company is slightly risky, he'll give it a 1.1 beta. None of that fundamental/regression beta formulae is used.

If people start ball-parking numbers (which is often the right thing to do), then very few bother just tweaking the Beta. You can then simply think about WACC as a hurdle rate and use an "out of thin air" number. If analysts start fiddling Betas, that probably just means they want to get the valuation to number X since it's the easiest thing to manipulate, just change the Beta by 0.05 and your valuation changes.

Aug 16, 2012

I would think through it conceptually. I'm going to guess that the vast majority of hot dog stands are 100% equity funded (not many banks lending into that business). So you have to determine the cost of equity, which would typically be done using CAPM. Risk free = 10yr treasury, equity risk premium = 6% or so, and you need a beta, which is a measure of the firms volatility relative to the market as a whole. Since the market for equity in hot dog vendors isn't widely traded, I would take a stab and say that the hot dog vending business is counter-cyclical to some extent and therefore beta would be <1, maybe 0.75. So .0345+.75(.06)=8.0% WACC.

Aug 16, 2012

^i respectfully disagree. most people would take out a small loan, so wacc would just be the cost of debt. seeing how small the setup costs are, the loan shouldn't be too large so they should be able to get it. more realistically, the person will use his own equity (whatever few grand he managed to save over the years), in which case i believe wacc should be the opportunity costs of what else the person could have done with his savings, which would probably be the risk free rate.

Aug 16, 2012

I'm willing to concede the small loan, which I could see. IN that case you're looking at whatever the cost of the debt is on a small bank loan. Not sure I follow the last part. Why would this guy go from investing the few grand he had saved into a start-up business (the hot dog stand) to putting it in a CD? Since these would be equity dollars, I think the comparison would be to the equity market, i.e. the CAPM cost of equity I discussed above.

Aug 16, 2012

thinking of wacc as a required rate of return, the hot dog owner is not required to give anyone a return since there are no outside investors, so using the equity markets is not necessary. the obligation is to himself since he is using his own money. so the guy would want to give himself the lowest cost of capital possible, which is the risk free rate (although technically he can require an even lower cost of capital from himself)

honestly, a break even analysis would be much more appropriate here.

Aug 16, 2012

Nowhere in the question does it say he is using his own money. Chances are if he is going to the equity markets its to get money he doesn't have...

NEVER lose your BlackBerry
www.conveniencesoftware.com

Aug 16, 2012

except for the fact that a hot dog vendor would be unable to raise capital in the public equity markets, hence being restricted to taking a loan or using his own capital

Aug 16, 2012

jackdaniels, your understanding of WACC, CAPM, and cost of equity seems to be completely wrong.

The idea of WACC and cost of capital deals with the use of capital and not the source of the capital.

As an example, let's say you want to borrow $1 million to invest into the stock market. Furthermore, let's say the average market return is 8% while you can borrow the $1 million from your friendly local bank at an after-tax rate of 4%.

Which rate should you use as your cost of capital for the $1 million investment in the stock market? 8%? 4%? Or a weighted average of the two rates?

The answer, of course, is 8% because that represents the RISK of the use of invested capital. The rate that you are able to obtain the funds is less important.

In the above example, you mentioned that the cost of equity should represent the "opportunity costs of what else the person could have done with his savings, which would probably be the risk free rate," however this is wrong since the opportunity cost of investing his savings into a hot-dog stand needs to reflect the required return of an EQUALLY RISKY project. This would not be the risk-free rate but instead a risk-adjusted rate.

Furthermore, the CAPM doesn't necessarily deal with the public equity markets, it simply provides an asset pricing model that accurately reflects the risk-return tradeoff attitude of investors. As long as you adjust the inputs appropriately, the CAPM model can give you any return that you are looking for (debt as well as equity).

Lastly, the idea of a "required rate of return" doesn't strictly deal with "outside investors" you mentioned. The required rate of return for any project is, once again, directly tied to its RISK characteristics and not the source of its capital providers.

Aug 16, 2012

In a WACC calculation the cost of debt is indeed how much you currently pay, or based on your risk profile, should expect to pay in interest on your borrowings. I'd probably use a high one similar to loans for small businesses or a personal loan.

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Aug 16, 2012

taylorman, you're wrong.

A "cost of debt" based on how much you pay (i.e., the actual interest rate on debt or the YTM on bonds) versus a cost of debt based on your risk profile (risk-free rate + risk premium) can easily be two completely different things.

A true cost of debt to use in the WACC calculation should be based on the INCREMENTAL cost of debt based on the ACCURATE risk profile of the project or firm in question.

Here's a quick example: Assume you're a fairly risky company looking to borrow some money to expand your business. Also assume that competitive interest rates at banks for companies with similar risk profiles are around 8.00%. Now, assume that you have a great relationship with a loan officer at one of the banks who promises to extend you the loan at only 5.00% because he likes you as a person and not because of the risk profile of your business. What is the correct cost of debt to use in your WACC calculation? In theory, you should use the 8.00% because that is the accurate risk-adjusted cost of debt for a company with your risk profile. In practice, however, we often use the 5.00% because it is more easily observable and because we cannot always estimate the risk-adjusted cost of debt.

Similarly, we often assume that banks (by determining borrowing rates) and the capital markets (by determining the YTM) provide good proxies for the actual cost of debt of firms (the risk premium over the risk-free rate). However, banks and the capital markets often misprice these borrowing rates because it is not always easy to estimate the actual risk profile of the firms in question.

Still, it is important not to confuse the actual underlying theory behind the cost of debt with what we actually do in banking for simplicity sake.

Aug 16, 2012

I'm pretty sure in a banking interview they're not looking for the academic explanation you're describing. Any banking analyst would either look at the company's present rate on term loans or comparable debt issues for companies with similar ratings for the cost of debt figure, I don't think there's any need to complicate it for the kid, especially since the banker in question is most probably not that concerned with what you're highlighting. He's not looking for an in-depth explanation of why capital markets misprice borrowing rates.

Aug 16, 2012

This was a IBD interview question used by Morgan Stanley a year ago

Aug 16, 2012

I think it's VERY important to understand the "academic explanation" behind potential interview questions.

My bank encourages us to ask these questions in interviews.

I'm just trying to help the kid out.

Aug 16, 2012

the CAPM as his risk is almost entirely unsystematic. The two sources of capital would likely a small loan from a neighborhood bank and/or his own capital. Cost of debt is the % interest payment, and for the cost of equity, I would just do cost of debt + X%

Aug 16, 2012

The one's saying taylorman is wrong, you should rethink your practical logic as well as what WE observe everyday. Also, the logic of risk adjusting WACC to exactly reflect the projected, risk-adjusted returns needs to be rethought. Sure, it is a good academic exercise, but not practical at all for many reasons. Before I go deeper I'll ask:

How are banks profitable and have market values that are higher than their book values?

What is EVA?

What is the idea of increasing sharholder wealth?

Aug 16, 2012

I clearly stated that my answer was more academic than practical. Still, for interview purposes, it is important that candidates show they understand the fundamental underlying principles behind.

I use the "practical" approach every single day, but I still enjoy understanding what the theory means.

Your second point makes NO sense. If you risk-adjust the returns (by which I assume you're refering to cash flows) there is no need to risk-adjust the WACC. In that case, just use the risk-free rate to discount all your cash flows (the Warren Buffett approach). Otherwise you would be risk-adjusting your cash flows TWICE.

Lastly, if you want to use the CAPM but face mostly unsystematic risk, simply adjust your beta coefficient to reflect total beta. To measure returns other than market returns in the CAPM, simply adjust your "benchmark portfolio" to whatever you're trying to measure and perform a simple regression analysis to find the relevant beta.

Aug 16, 2012

Personally, I would not decide whether to buy or sell a company based on WACC, especially on a stand-alone basis. If you had several companies in an industry that were identical in operations, market share, profitability, etc and the only difference was the capital structure of the companies, then I would "choose" the company with the lowest WACC since you'll then be discounting the future cash flows of the company by less, thus rendering a higher valuation relative to the rest.

Aug 16, 2012

Agreed with above. WACC alone does not tell you anything about buy/sell. If the company pays out a dividend, you can use the WACC in the dividend discount model to figure out if the stock is over/under valued by the market and based on this you would sell/buy.
You can use the WACC in a DCF to do the same if the company does not pay dividends.

Aug 16, 2012

Just to to be specific, you would use the equity component of the WACC for the dividend discount model, which is your cost of equity.

Aug 16, 2012

It depends where you are on the U-curve. An increase in debt is going to raise your levered beta, which will raise your cost of equity. However, the weight of your equity will decrease. Your cost of debt will most likely increase as well, but the weight of debt will increase too. If you are to the left of the inflection point on the U-curve, raising debt will lower WACC.

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Aug 16, 2012

Thanks Buddy

Aug 16, 2012

Par

Aug 16, 2012

be consistent with how you treat debt. if you used market/ytm for debt, then use market. otherwise use par, if debt is shown par

Aug 16, 2012
eiffeltowered:

be consistent with how you treat debt. if you used market/ytm for debt, then use market. otherwise use par, if debt is shown par

I did use market/ytm for debt. How would I go about calculating market value of preferred equity? Are pref stock values published somewhere?

Aug 16, 2012

If you can't get a quote from bloomberg then ask ECM/DCM for a OTC quote. If that's too much trouble use book and note it.

Aug 16, 2012

You should only use one WACC for all the years' cash flows. If you want to vary debt levels for different years, use the APV method. On the question of the 2 debt rates, I'm not too sure what you're asking but in any case take the weighted average cost of debt as the debt rate input for the WACC.

Aug 16, 2012

new capital structure.
gg

Aug 16, 2012

Why would you do a wacc of the financing itself... that's a bit circular

Aug 16, 2012

New one because obviously the WACC changes when changing the debt/equity mix due to increase in shareholder risk.

Aug 16, 2012

What the fuck are you people talking about?

Use the optimal capital structure -- which is assumed to be market capital structure for the comp set -- for the WACC calculation. For DCF purposes, its a hypothetical transaction and the actual capital structure the transaction is being premised on does not inform the enterprise value.

Unlevered DCF is does not assume interest expense or mandatory amortization. A hypothetical buyer can use any capital structure he/she desires, and can use whatever cash flows are generated to service whatever capital structure they choose to put on this company. Similarly, the actual capital structure being used in the transaction should not inform us on WACC since its apples and oranges? Instead, we assume that a hypothetical buyer will use the OPTIMAL capital structure, which we assume to be the capital structure of the comparable companies in the public market.

Aug 16, 2012

marcus,
wtf are you talking about. your just adding on to our point.

Aug 16, 2012

Hows that adding to you point? You claim he should use the NEW capital structure.

I'm talking about for valuation/DCF purposes.

Aug 16, 2012

I think he's referring to the calculation of the acquiring company's NPV

Aug 16, 2012

Piper - you're talking about 2 different things

He's saying for DCF you don't know the new capital structure ... as you're doing a DCF of a target in a hypothetical transaction using comps and the optimal cap structure.

I think some people just misread what the op was asking marcus

Aug 16, 2012

Ugh.... use the weighted cost of capital?????? WTF?

Aug 16, 2012

^^^ yea, very helpful

use the average leverage from comps. you want the "long term optimal" capital structure not what is a snapshot in your company's evolution.

Aug 16, 2012

Sometimes people make things more complicated than they are...... just sayin'

Aug 16, 2012

Agree with above comments that the cap structure of this particular hypothetical transaction is irrelevant. To take that a step further, the only real number of interest here is the overall risk of the target enterprise. That risk does not change along a normal spectrum of possible financing options. More debt simply adds more equity risk and overall risk stays constant. It's good and informative to know the market cap structure of similar firms but again the only number of interest here is the asset beta of the target enterprise. Adding or removing debt does not change the risk of an enterprise as a whole, just reallocates it among the various stakeholders. A DCF is a firm level calculation, so how the total risk might be split up among some hypothetical stakeholders tells us nothing about the NPV of a purchase of a firm's cash flows.

Aug 16, 2012

Ok, I'm going to stop post on this thread because its a joke.

I don't advise anyone reading this thread to ever consider anything people are saying to be true.

Aug 16, 2012

Boys, the WACC should be computed on the specific acquisition / project

Period

#

#

#

The time is now, seize the day ...

Aug 16, 2012

Marcus, my text is telling me that for CAPITAL BUDGETING, to be perfectly accurate firms will ideally use the cost of capital of the project's financing. For example, if a start up project is financed entirely with 10%debt, then 10% should be the discount rate for that project's cash flows, regardless of the firm's capital structure.

If that's true, then wouldn't the discount rate used to value a company depend on the how the purchase is financed? In other words, how is a company using its capital to buy another company different than a company pursuing a capital budgeting project (in terms of what cost of capital to use)?

Aug 16, 2012

Cost of capital is an opportunity cost. The opportunity cost for any project is the return you'd expect for a project of similar risk. This concept has nothing to do with the interest rate you are charged to finance the project.

The opportunity cost of running a lemonade stand is the return on a project with a similar risk to running a lemonade stand. This risk is an operational risk and, within a normal spectrum of capital structures, has NOTHING to do with how the project is financed. Think about it, does the fact that you bought ice cubes by selling equity or debt have ANYTHING to do with whether those ice cubes will accidentally melt and you go out of business? Do the ice cubes care how they were financed? Will less debt make your particular street corner have more foot traffic? Will borrowing at 5% rather than 4% cause the summer to be cooler and business to be worse?

Aug 16, 2012

There is no right answer
but "the company's WACC after the new financing based on its new capital structure" is the bad answer.

I would use the project WACC because it might be riskier than the whole company. (This is the conservatve way)

Comps capital structure because eventually the company's structure will converge to this.
The company WACC works too because it's the opportunity cost of the investment.

Aug 16, 2012

^The last statement is only true ASSUMING the project bears the same risk and precisely mirrors the company's operations/other projects, right?

Aug 16, 2012

It's because the FCF will be growing by g every year. It's a math trick to account for the continued growth in the numerator.

Aug 16, 2012

No offense, but this is a bit old. And horribly put together. And....not that funny, really.

Aug 16, 2012

guess ive been out of the loop then, my bad.

Aug 16, 2012

Might not suck so much if the rapper didn't suck

So what do you do?
-I work for an investment banking firm.
Oh okay; you are like my brother, he works for Edward Jones.
-No, a college degree is required in my profession

Reality hits you hard, bro...

Aug 16, 2012

yeah, hilarious........

...............................................

Aug 16, 2012

Not all preferred equity has a convertible feature, although this feature does lower the security's required cost of capital.

Preferred equity is less risky than retained earnings (common equity) primarily due to the fact that preferred equity is senior to common equity (although both are unsecured) in the cap structure. Also, preferred equity generally accrues interest at an explicit rate - this accrual amount is also senior to the common equity, which it effectively dilutes.

Aug 16, 2012

.

Aug 16, 2012

bump

Aug 16, 2012

its a maturing instrument with a coupon

Aug 16, 2012

.

Aug 16, 2012

Dividend/Price per share=yield=cost

KICKIN ASS AND TAKING NAMES

Aug 16, 2012

good looking out budfox.

Aug 16, 2012

Investors will accept a lower rate of return on the preferreds because of the semi-guaranteed return it pays out. Retained earnings has the highest required return because it is the most variable and nothing is guaranteed.

You could argue that preferreds are more senior in the capital structure, but this is of secondary consideration since they are usually unsecured "junior" securities.

Aug 16, 2012

Yields on corporate bonds or using a spread on risk free. Just assume return on market assumed to be 6%.

Aug 16, 2012

You calculate the before tax by looking at Bloomberg, or possibly the Federal Reserve site (they have Baa bond yields). Find the company's credit rating, and use that to find the company cost of debt as of the valuation date.

This site, didn't read all of it, but looks like it has some good info on WACC.

http://business.fullerton.edu/finance/mstohs/Calcu...
Use the marginal tax rate to calculate the after-tax return.

Aug 16, 2012

Equity risk premium (e.g. Rm - Rf) is assumed around 5-6% - Damodaran puts it around 5% these days if I recall correctly. Cost of debt above posters are spot on.

Aug 16, 2012

Asume the debt is a bullet bond with the same Duration.
Rd= Rf (usually 10 Y T Notes, 5Y works too) + spread + CountryRisk

  • b
  •  Aug 16, 2012

Yes. Interest payments are tax deductible.

Aug 16, 2012

yup. also, it is (1-t) b/c of interest being a physical CF. as oppsed to depreciation, which is simply multiplied by the tax rate when it comes to incorporating the tax shield.

Aug 16, 2012

I can't believe I still remember this crap. I guess passing level one does have benefits.

Aug 16, 2012

in the real world, WACC is always 8% for a regular company, 10% for something spicy, 12% if based in a country you never heard of.

Aug 16, 2012
John Mack:

in the real world, WACC is always 8% for a regular company, 10% for something spicy, 12% if based in a country you never heard of.

Not so sure the gaps between these benchmarks hold given the current liquidity drought - probably a bit wider at the moment...

Aug 16, 2012

smuguy is absolutely correct

Aug 16, 2012

my post was more a comment on the waste of time spent over an academic argument when the value lies in interpreting the financial prospects of the company.

Aug 16, 2012

Always use market values when calculating weights.

So:

MV(E)/[MV(E)+MV(D)+MV(P)] for equity
MV(D)/[MV(E)+MV(D)+MV(P)] for debt
MV(P)/[MV(E)+MV(D)+MV(P)] for preferred

So assuming those weights are market values (and one of the preferred is meant to be an equity), it would be 50% debt.

"Success means having the courage, the determination, and the will to become the person you believe you were meant to be"

Aug 16, 2012

Assuming that $9mm pref is actually common stock, it would be 50% debt, 40% equity 10% preferred. Always use market values and total MV of capital.

Aug 16, 2012

PSD and Asatar already answered your question, but given your listing of options 3 and 4 it seems you were generally uncertain about wether to use XYZ/enterprise vs. XYZ/equity ratios:

a) For WACC weights, you use XYZ/enterprise ratios (as explained).

b) The debt/equity ratio comes into play when delevering (and relevering) beta factors (e.g. Hamada formula). I assume that's where you've seen it used.

Aug 16, 2012

Your question was answered pretty well above.

This paper isn't great, but it might help you get a better understanding of the WACC.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id...

Aug 16, 2012

I'm confused as to where you guys are getting the 50% from; WACC is based on market values as the previous posters said, and the OP says MVE is $90M at the time of valuation and EV is $100M. Assuming no excess cash EV = D + E + P = 100. The $10M debt, $9M equity, and $1M preferred are the initial book values of debt/equity/pref. So if you're assuming market value of debt = book value, then it should be 10% debt.

Aug 16, 2012

He said $10mm debt, $9mm preferred (assuming this is a typo and means common), $1mm preferred. Total = $20mm, therefore debt = 50%.

Aug 16, 2012

It would be 50% debt, 40% equity 10% preferred I guess.

Aug 16, 2012

Investors will require a higher return to make up for the increased risk = higher cost of capital = higher WACC....

Thats how I see it.

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Aug 16, 2012

levered beta is usually higher

Aug 16, 2012

I never post on these types of questions but I'm bored and can't sleep, but really? On the most basic of basic levels, just think about the definition: weighted average cost of capital. Capital (equity or debt and everything that comes in between) costs more the riskier you are. If you're an individual and have no/bad credit and little income, your interest rate on a credit card will be higher than a good credit and high income person. In a corporate entity that spreads across the capital structure-equity and debt and everything in between and the amount of debt (which is less expensive than equity) compared to the amount of equity that you should or need to have will determine the cost of capital. On the equity side the lower the risk, the less return they'll expect and therefore the lower cost of equity based on the valuation of the company. The classic example is a utility company with a near monopoly market and regulated pricing power versus a startup that's an idea with possible cash flow in the future, so the utility requires a lower return for the equity investor (and in that case a dividend) to invest in your company and they'll value your company higher because they don't need to make as much money compared to the startup that they'll value lower. On the debt side it's the same (lower interest rates) but at the same time the debt investor (who's also at the top of the capital structure upon liquidation, and there can be multiple levels of debt, but this seems pretty elementary) will lend your company more money if your company's ability to repay that debt is more likely. So instead of having to finance your company with all expensive equity, you may be able to finance it with lower cost debt. When you combine those two in easily googled formulas, that's your wacc.

In reality it's more complicated but that's how I'd tell the guys I had done my liberal arts major with, and when I quickly picked up a finance double major 22 years ago.

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Aug 16, 2012

Because if it's "riskier", then it's going to have a higher beta in your Cost of Equity Calculation.

Recall: Cost of Equity = Risk-free Rate + Beta * Market Risk Premium

So, if Beta increases, so will our Cost of Equity.

Now recall:
WACC = (Cost of Equity * % of Equity)
+ (Cost of Debt * (1 - Tax Rate) * % of Debt)
+ (Cost of Preferred * % of Preferred)

Just think: "If my Cost of Equity is now higher (because of the higher beta/"risk"), that also means that the first part of the WACC equation is higher, effectively increasing the sum of all 3 parts of the equation."

Or, you could just think about it conceptually and say that because we're running such a risky company, we are going to have to pay more to convince our lenders to give us their money (translating to a higher cost of capital).

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Aug 16, 2012
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Aug 16, 2012