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.
Aside from what WACC actually is, because it serves both purposes in a sense, it is not clear why it is used as the discount rate. The entire point of the bond example was to show that discount rates in bonds are used to show how attractive an investment is relative to another investment. WACC is not used in comparison to another security, so it is more difficult to understand why we use it.
What investors expect to return is the cost of capital. They are charging x% return for the capital they are providing. You lost me with that example though
What the hell are you talking about?
I am just trying to understand this haha. I am guessing I am totally off-track here?
Perhaps you (OP) are confused as to "who" uses WACC to evaluate various investments. as TT said your first example seems a bit off.
Who do you (OP) think uses WACC to evaluate an investment?
Calculating WACC (Originally Posted: 05/08/2015)
They can issue debt for 12.5% with tax rate of 20%. They can issue preferred stock at 14% (net of flotation costs). The can issue common stock with a required rate of return of 16% (net of flotation costs). Calculate the WACC.
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.
I took a stab at this even through this was geared towards OP. btown I'm getting around 36-37%? Am I way off?
Interesting since that's 3x the answer, write out your process and I'll help you out.
.
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%
decimal is off. 12%
As Skinnayyy said, the decimal is off but good job.
Thank you so much
WACC question I can't seem to solve (Originally Posted: 11/15/2012)
I have this difficult problem I can't seem to solve. Can someone please help me?
Answer: 5.91 %
What is now the WACC for Blue?
The answer should be 13.4 %, but I don't understand how to find it.
.
Where is this question from?
Well, you've added debt to the capital structure which, according to MM proposition 2 makes the equity more risky, meaning that the cost of equity should increase.
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.
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?
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.
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.
WACC Problem Help.... (Originally Posted: 04/06/2016)
Having a lot of trouble with my corporate finance class. We were given a problem that needed all parts of WACC to complete. And I can't figure it out. At all.
All help is appreciated. I attached an image.
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 basic, definition level kind of questions, so if you cannot figure them out, you shouldn't be doing finance, because you are showing no efforts at all
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 0 no
yeah you're showing no effort at all. but TBH off the top of my head definitely didn't know how to calculate anything except cost of equity ¯_(-__-)_/¯
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.
WACC (Originally Posted: 07/07/2017)
Dear All, I want to calculate the cost of capital for local government. I am struggling to calculate the cost of equity - I can use the CAPM or the growth model because there are not comparatives for local government given that government is the only shareholder and local government is not listed on any stock exchange. Please assist.
Can you own the government?
In Soviet Russian, government owns you!
Gave you an SB just for the funnies
What you're trying to do is inherently nonsensical, but if I had to do it, I would use the following method:
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).
Why WACC deserves more eye-balls (Originally Posted: 06/09/2014)
A Discounted Cash Flow (DCF) Valuation seems pretty straight-forward on the surface. It’s one simple magic formula that satiates or revokes future investors and analysts alike.
PV = CF1 / (1+k) + CF2 / (1+k)2 + … [TCF / (k - g)] / (1+k)n-1
Where: PV = present value CFi = cash flow in year i k = discount rate TCF = the terminal year cash flow g = growth rate assumption in perpetuity beyond terminal year n = the number of periods in the valuation model including the terminal year
Lurking beneath the surface is a mild issue which may pose severe problems if left unnoticed.
We are used to a firm-wide WACC for most DCF models. According to recent research though, there might be some merit in favoring a division-wide WACC instead of a firm-wide WACC. Agreed that a DCF gives an overall, wholesome picture about a company’s finances but there are inevitable distortions introduced by using a single discount rate for the entire company if we are only interested in valuing a specific division of a firm for investment purposes.
The firm-wide WACC and division-level discount rates match only when the division under consideration has the same risk profile as the entire firm. In other words, the division needs to be a carbon copy of the rest of the firm, which is highly unlikely in most cases. For diversified firms, this implies that we could be overinvesting in their high-beta divisions and underinvesting in their low-beta divisions by favoring a firm-wide WACC. Thus, it would lead to overestimating the NPV of a division when it is riskier than the typical projects in the firm and vice versa. This could have real effects on important corporate policies such as Corporate Investment and Mergers & Acquisitions.
Although it has a cost attached, some analysts do choose to go for multiple-discount rates to value different divisions of a single conglomerate. The costs though, may not be simply computational. There might also be an organizational cost which could lead to politicking of the capital budgeting process.
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.
Finance 101? Why on earth is this even front paged? Next post: buy low, sell high Thanks Sherlock
Beta lol
WACC - estimation (Originally Posted: 12/30/2014)
Hi to everybody!
I am evaluating a German Company: as risk free rate to use in the CAPM formula is correct if I use the 10 years german gvt bond even though right now the yield is 0,55%? Using that my final cost of equity will be very low! Beside, should I use the same when I compute the cost of debt?
Thanks for your help!
This may technically be correct, but oyou may want to adjust the yield upward to approximate a historical average to take into account the fact that depressed yields are temporary.
Ut modi ut recusandae sunt sint vel explicabo a. Sunt fuga rem consequatur labore modi et. Ipsum quia qui consectetur ut cupiditate. Error tempora qui optio amet.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...
Illum aspernatur in aut itaque error nisi aperiam error. Quo exercitationem saepe sit nihil. Dolorem ut commodi mollitia. Ratione maxime incidunt quia explicabo laborum fugiat id fugit. Eum consequatur quo sunt perferendis.
Dolores ut consectetur cum ullam in quae aut. Accusantium ipsum tempore eum quasi ea. Nam non necessitatibus necessitatibus vel enim modi. Eaque nobis repellendus rerum est. Dignissimos provident sint excepturi eum natus nihil laboriosam. Et ipsa provident vero quo modi eveniet ea facilis. Ut recusandae sit ut tempora qui est.
Qui quis occaecati voluptas perferendis laborum. Aliquid voluptas quisquam aliquam porro quia voluptas. Velit doloremque corporis fuga qui eius mollitia. Et eius facere harum nam eaque.
Incidunt sed velit tenetur ratione. Neque nobis earum incidunt. Itaque enim eveniet fuga quia.
Sit impedit ea magnam aut. Libero aspernatur velit voluptas ut qui quisquam nulla. Ut ea praesentium molestias. Porro sit neque qui totam adipisci. Quibusdam sunt at non.
Consequatur sunt itaque quod odit aut et. Rerum rerum nihil non qui ducimus. Et et suscipit et nihil aliquam rerum et enim. Culpa error nulla ipsam ipsam molestiae veritatis iure. Voluptas aut eius tempore molestiae maiores perferendis.
Veritatis assumenda ratione quisquam. Ducimus quia est ea eaque rem a. Et architecto aut mollitia nisi incidunt. Amet praesentium tenetur dolor esse aperiam impedit fuga.