While using a DCF and WACC, where do I input my own required rate of return?
Hi everyone,
From an investors perspective while calculating a DCF(FCFF using WACC), where do I put in my own required rate of return? Do I replace the cost of equity with my own return in the WACC formula?
**Wacc Calculation **
Target Capital Structure
Debt to Total Capitalization 29,1%
Equity to Total Capitalization 70,9%
Debt to Equity Ratio 41,8% O
Cost of Equity
Risk-free rate (2) 2,5% Interpolated Yield on 10-year Treasury bond
Market risk Premium (3) 7,1%
Levered Beta (4) 1,22
Size Premium (5) 1,7%
Cost of Equity 12,8%
Cost of Debt
Cost of Debt 12,0%
Corporate tax rate 22,0%
After Tax Cost of Debt 9,4%
WACC 11,8%
Let's say that I want a yearly return of 20% on this investment to cover the rate I believe I can get longterm from indexfunds and a riskpremium in this specific company. Would the WACC to use then be 20%(My required rate of return)+9,8%(Cost of debt) = 29,8%?
Thanks
Almost correct. It will be 9.8% * [preferred debt ratio] + 20% * [1 - preferred debt ratio]. Debt is supposed to make your return higher (or allow you to offer a higher price for the same return). Think of it from the following perspective:
When you make a 100% equity transaction, you require a certain rate of return, say 20% (these days in practice it is way lower, think 15%). If you put leverage on that same transaction, you will still require the 20% return on the equity-financed part of the investment, but the entire investment also includes debt, which requires a different (lower) rate of return. In practice this is usually the interest you will pay on the leverage for that investment. Hence your rate of return on your investment will be the weighted average of 20% on the equity part and 9.8% on the debt part.
This is why your return increases for debt transactions. Instead of discounting with the 20%, you can discount with a lower %.
From your formula you need to remove taxes for debt too I guess?
Correct
Thanks, please evaluate this further? How would the formula look instead?
D * (1-t) * D/(D+E) + K * (1-D/(D+E))
Where D = Cost of debt (interest paid over leverage) t = Tax Rate D / (D+E) = Preferred/optimal debt ratio K = required return on equity
It's just the weighted average of the required return on debt and the required return on equity, hence weighted average cost of capital or WACC. I am not sure how to explain this any further.
Many thanks!
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