Concise interview answer to what the difference of cost of capital vs WACC?

### What is the Cost of Capital vs. the WACC?

When talking about discount rates, the term "cost of capital" and "WACC" are sometimes used interchangeably - but it is important to draw a distinction between the two. Put simply, the cost of capital is a generic term for the cost of obtaining capital to run a business.

### What is Weighted Average Cost of Capital (WACC)?

WACC represents the cost that a company incurs to obtain capital that can be used to fund operations, investments, etc. The Weighted Average Cost of Capital includes the cost of equity financing (issuing shares to investors), debt financing (issuing debt to debt investors).

Now we bring them all together to find WACC.

**WACC = cost of debt + cost of equity + cost of preferred stock**

#### What is the Debt Cost of Capital?

The cost of debt looks at the amount of debt in the capital structure and then multiplies that by the weighted average interest rate. This is done to reflect the interest rates of the company's debt - which is the cost of having debt investors. Then you multiply by (1 - tax rate) since interest payments are tax deductible.

Since interest payments are paid before paying taxes - by increasing the amount of interest payments you end up paying less taxes then you previously did.

**Cost of Debt = weighted average interest rate * (% of debt in the capital structure) * (1 - tax rate)**

#### What is the Equity Cost of Capital?

This is the cost associate with selling part of a company to investors. The equation can be seen below.

**Cost of Equity = Capital Asset Pricing Model * (% of equity in the capital structure)**

Put in simple terms, CAPM is the equity equivalent of the weighted average interest rate for debt.

**Capital Asset Pricing Model = risk free rate + Beta * market risk premium**

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## Comments (42)

Cost of capital is investors' required rate of return on company stock whereas the weighted average cost of capital is the rate used by companies to discount future cash flows back to their present value taking the entire capital structure into account.

Considering my username I feel somewhat obligated to chime in here...

I agree partially with the above but cost of capital does not necessarily refer to the total cost of all your capital sources, it can refer to the cost of debt, cost of equity, preferred stock or all of the above. If you start a company with 100% equity and your investors require a 10% return, your cost of capital is 10%. On the other hand, if you somehow get a 100% LTV loan at 6%, your cost of capital is 6%.

Because WACC is a weighted average it necessarily takes into account all sources of capital to compute the rate you would use to discount free cash flow to the firm or unlevered cash flows to derive an enterprise value for the firm. If you have 50% debt/50% equity at the rates above and a 34% marginal tax rate and no preferreds, your weighted average cost of capital (WACC) would be:

[.5

10%] + [.5 * 6%(1-.34)] = 6.98%Keep in mind though that you discount with the cost of the capital associated with the cash flows -- if it is an all equity company or if you are discounting levered FCF you would use the cost of equity.

fdba Emory Blaine and BBA or otherwise trying to find the perfect pseudonym.

I agree with wiggity but there also a belief that:

Cost of capital is the return asked from the assets (<> ROA)

Only when the firm is unlevered, the Cost of capital = WACC = Cost of Equity.

And there is also the ROIC ...

There are many beliefs out there, a lot of ppl in CF/IB/S&T hadn't taken the time to read McKinsey's nor Damodaran's books on valuation. My boss who calls the IRR ROA ...actually had the nerve to tell me "Are you reinventing finance theory?" when I used the right formula for estimate the ROA.

Well said Sir

Are these the books?

http://www.amazon.com/Valuation-Measuring-Managing... http://www.amazon.com/Damodaran-Valuation-Security...

This book is awesome also, it is all application: http://www.amazon.com/Financial-Modeling-3rd-Simon...

fdba Emory Blaine and BBA or otherwise trying to find the perfect pseudonym.

Kinda:

Mckinsey (There's a fifth edition I just ordered)

Damodaran (I got Investment valuation 2nd ed)

Anyway best book out there is Investment banking from Pearl and Rosenbaum

Make sure you download the xls files that are bundled with the book. They are great.

(of course all these books are also on the web as downloable ebook if you want to save some money)

Visiting macabacus.com wouldn't hurt neither ...

Question for buysiders on WACC(Originally Posted: 06/26/2013)I have a weird question on WACC that hopefully somebody can shed some light on. Note: this is targeted more for the hedge fund/mutual fund community, not for IB or PE.

WACC is comprised of two parts: cost of debt and cost of equity. Cost of debt is straightforward and I have no issue with it, but cost of equity is traditionally modeled with CAPM which is reliant on EMH. From an alpha seeker's point of view though, how can the use of a metric which depends on EMH be justified?

I understand that buyside analysis doesn't really get into full-blown dcf's that much, but WACC also goes into other things like EVA etc.

Is this just too minute to care about or am I overestimating how often WACC is used on the buyside? Thoughts?

Yes, you're overestimating how WACC is used.

Most buysiders use multiple-based analysis to estimate the value of a company. Think "more art than science".

What IS useful about DCF analysis is the framework that forces you to think about the working capital and capex intensity of the business.

With regards to EMH and trying to see if the current stock price will result in alpha vs. the WACC calculation...I've never seen that applied. That's because CoE is not observable and most of the DCF is reliant on the terminal value.

EDIT: One more thing. I frequently use NPV analysis whenever I'm doing a SOTP analysis and I want to give the company credit for a reliable stream of cash flows, such as a long-term contract. In those instance, I use my CoE of 15%-20%, not the company's. That's because of think of myself as a business owner/investor and that's the return on I want on my capital.

Let's take a step back. Using CAPM in a practical way doesn't rely on the EMH. You can within reason calculate the cost of equity for a pool of liquid securities (folks generally use the SP500) based on observable inputs. When the "alpha seeker" then analyzes individual securities in that pool, he/she might find a stock trading at the average implied cost of equity, but the beta of the business (which in this case approximates the underlying volatility of the business relative to the underlying volatility of all of the businesses in a pool) is much, much lower than 1.0. The alpha seeker has therefore found an opportunity to buy a lower risk asset at an average price. Over time, the market will bid up the price of that asset as investors are being over compensated for that risk, relative to other opportunities in the market.

The guy above me who believes that his supposed 15% - 20% cost of equity at his fund level is what he should be NPV'ing against at the individual security level, doesn't understand how the market works. Your cost of equity when dealing in public securities, is at all times equal to the cost of equity present, on average, in the market. It is possible (with a lot of work and even more luck) to ACHIEVE a 15%-20% return at the fund level over an extended time series, but you don't do so by applying your arbitrary cost of equity to the securities you analyze. You do it by owning securities which are underpriced relative to other opportunities in the market, and taking profits when the underpricing corrects.

Let's use an example. There is a company whose assets are comprised of $100 million in cash. The company has no expenses. The company is going to distribute all of the assets of the business to shareholders, tax-free, in 365 days. The stock is trading at $95. 1-yr T is @ 25bps. Is the stock a good deal at $95? Hell yes it is. You make a risk free trade at a 5.3% IRR if you have to hold it for the whole year. Of course, this won't persist in the market for long. The stock will rise to $99+ pretty quickly, as the marginal buyer/seller of the stock bid away the excess return. If it takes 3 months for the stock to reflect a forward IRR that is more appropriate, and the investor buys @ 95 and sells @99, that investor realizes an 18% IRR. Of course, if you apply your arbitrary 20% cost of capital to every such situation, you will never put money out the door, unless you are screwing up your business analysis.

Coming from the buy-side, most guys I've worked with or networked with from other shops use multiple based analysis. Most common multiples used are EV/EBITDA or EV/Sales if company is not currently profitable. In my opinion more of the value-add comes from two things:

1. Why are your earnings numbers right! Be able to support and justify your earnings power estimates with relevant key performance indicators and industry data. If you don't get the denominator right, your multiple is wrong.

2. Why is that multiple you are using appropriate for this situation! All too often I've seen guys put comparable multiples and expect the market to correct the gap. First and foremost, explain the discount. Second why is that multiple appropriate.

Thanks for the good responses.

@ Karateboy - That makes a lot of sense and is kind of what I was expecting. With respect to the SOTP analysis, I see your reasoning there and at the very least it's more conservative to use a higher cost of equity.

@ RLC1 - I'm not completely sure on one part of your explanation.

"When the "alpha seeker" then analyzes individual securities in that pool, he/she might find a stock trading at the average implied cost of equity, but the beta of the business (which in this case approximates the underlying volatility of the business relative to the underlying volatility of all of the businesses in a pool) is much, much lower than 1.0"

My question is would you use the implied cost of equity or attempt to use your own (lower) real cost of equity in this case? It seems to me that you shouldn't use a product of your analysis (real cost of equity) as an input into other metrics for comparison (WACC) as you're assuming an arbitrage situation without necessarily actually finding one.

My first instinct is to agree with Karateboy on this as it doesn't seem to me that the real cost of equity is observable, but I don't think I'm 100% clear on your argument so if you could elaborate that might be helpful.

@ RPRuggaard - Definitely agree that multiples are more commonly used. Thanks for the feedback.

Woah, woah woah. Let's take a step back here. Don't jump on this forum and accuse anyone of not "knowing how the markets work" just because you passed your intro to finance class.

Your arbitrage pricing example is only valid in those simplified instances. There are very limited applications of this concept when valuing individual securities. I also disagree with your reliance on correlation as it tends to go to 1.0 when you need it most. When we're talking about fundamental analysis from the perspective of an value-oriented equity analysis, real life rarely acts like a spreadsheet.

As support for my statements, just look at the most successful investors today. It's all about understanding the intrinsic value of the business, not about arguing the discount rate.

At the end of the day we are all predicting the future, and we're going to be wrong fairly often. That's why we use an arbitrarily high discount rate. My example is one of how things are done in the real world.

I'll let other professional chime in, but there's a reason why the academic approach is not heavily applied outside of the university.

WACC range, sensitivity table, done. Next.

That solves nothing - its a "no answer" answer. Either your WACC range is ridiculously tight or your output value range is ridiculously wide.

Wow. It's because KarateBoy (was hoping I could think of some martial arts reference but couldn't) there is no right answer. There is no one value for a company, you're trying to get a sense for what it is worth not a stationary number.

Sorry, if my answer came off a bit dick-ish.

I agree with you there is no precise value for a company. However, the point I was trying to make is that the terminal value is too sensitive to changes in WACC to offer much insight.

its like saying AAPL is worth between $350 and $650. Doesn't help anyone.

The equity risk premium is observable, and practically useful provided you are using an ERP data set that is calculated consistently across time (e.g., one data source). Read through Damodaran's blog for more info on this. When you look at an individual security within the SP500 (or other pool), you take the ERP of the MARKET and adjust it for the "risk" of the security relative to the SP500 (which represents your opportunity cost of investing). This is not a strictly academic process (you need judgment and research to ensure you are using an appropriate risk coefficient, for example, or you might consider using a higher adj risk free rate when you are in a low int rate environment). Fundamentally what this enables you to do is state that, for a given set of investment opportunities, an individual security offers a greater/lesser return than the other opportunities per unit of risk, which creates alpha opportunities.

You do not simply throw a 15% cost of equity into your calculation because that's your fund's arbitrarily stated cost of capital. To use another simple example to illustrate how utterly incorrect that is, consider a company with zero net debt, vs. the exact same company with 7x debt/ebitda and 1.5x interest coverage. Is 15% the correct equity return for both scenarios?

If you want a short cut to the DCF, don't use multiples, even though it's popular among the inexperienced. Use unlevered and levered free cash flow YIELDS, which correlate directly to cost of capital calculations. FCF yields, in combination with an informed and conservative view on cost of capital, and the gordon growth formula, is more likely to result in long term investment success than any of the other crap you hear on wall st.

I've just told you everything you need to know. Go make a billion.

Questions regarding WACC(Originally Posted: 08/06/2013)I understand the basic logic behind WACC, and I have used it many times before, but it was usually given to me. I am trying to figure out how to calculate it and I have some questions that maybe you guys could help on:

1) Why is the cost of debt tax-effected in the first part of the equation? Really, what is the logic behind this

2) What exactly is the "Market Value of Debt"?

3) When calculating the cost of equity using CAPM, is there another good risk free rate to use besides the 10-year U.S. Treasury?

4) In CAPM, where can one derive the estimated market return for the market risk premium?

Thanks guys

"An investment in knowledge pays the best interest." - Benjamin Franklin

1) In the vast majority of economies, interest payments on debt are tax deductible. Say you borrow $100 and pay $5 per year in interest, you can take that interest away from your operating profit. At a 40% tax rate this means you save 40% of that interest in your net profit so the actual 'cost' is only $3.

2) The current yield on your outstanding (or similar) debt. Say a AAA rated corporation wants to issue 10Y debt and similar bonds are trading at a yield (NOT coupon) of 4%, this is the market value of that debt. You can either use comparable company debt or existing cost of debt for the company.

3) Not really. Use UK gilts, German bunds etc for your country of origin.

4) Your bank will usually have standard numbers for this or you can look at average 5Y return versus index return.

The issue with WACC is the old adage "garbage in-garbage out". You can make so many assumptions with regards to the cost of equity that you can basically come up with any discount rate you want.

Great, thanks for your answer all of those. For #4, do you get the expected market return using an average 5Y historical return for the target company? Not sure what you meant with this one exactly

"An investment in knowledge pays the best interest." - Benjamin Franklin

Agree with everything here - slight touch-up on 3) which is that some will use a risk-free rate that reflects the length of the investment. If the investment is in a different country, the local rate or an inflation adjusted rf rate is used.

The market return is the expected return of the market. Usually just a guesstimate or market consensus of how the market will perform going forward. As mentioned before, it's something that will be given to you and may vary slightly between banks.

If you want to find your own market risk premium, you can go figure it out by looking at the long-run returns on Bloomberg, or even just poking around on Google. Damodaran probably has some information on his website.

The problem with this approach is that the MRP can vary very widely depending on what time period you're looking at.

Alright cool thanks guys

"An investment in knowledge pays the best interest." - Benjamin Franklin

You guys have it all wrong. You're meant to input target valuation (important to source it from someone sufficiently senior), and use the goal seek function in excel to get your WACC. Then you can fill in the blanks in the WACC equation - I usually prefer to tweak the equity risk premium.

Good thing about Damodaran is that he updates the equity risk premiums using a few methodologies, so you can usually find one that works.

This is pretty hilarious, and 100% true.

Not trying to be a dick, but can you elaborate on this method? If you're running a DCF to get to the Operating Value it's just the value of all of the CFs (including the TV) discounted by the WACC. How would I know the Operating Value before I have a WACC in order to work 'backwards' like you're suggesting? Are you putting this in the context of a transaction where Management has a 'price' that they'd like to sell at, and then you're working backwards?

'Before you enter... be willing to pay the price'

He's saying that in the real world, you don't work from assumptions to the final value. Your MD will have a value which he thinks will make the deal to happen and he will say something like "I think we can probably suggest a price in the region of x, let's run the numbers" and you then go away and find a way to validate that number.

Haha. Although you have a lot more flex playing with the cash flow projections than you do with the WACC.

Makes sense, thanks.

'Before you enter... be willing to pay the price'

One of my favourites is when MDs don't like the valuation, spend 5 seconds pretending to look at the appendix, and go "hmm, it just FEELS like the WACC should be lower"

So yeah, that's another good technique to calculating WACC. Just feel it out.

But on a serious note, I bloody hate the whole concept of WACC (mainly the CAPM bit). The idea that correlation of volatility should arbitrarily have a linear relationship with return is just ridiculous to me. One of my biggest pet peeves... Along with "just take the average of the comps and add a 30% takeover premium"

#4 As per my understanding for estimating market premium we should use long term average for calculation of premium returns for the index ... may be 10 years for mature markets such as US and 5 years for Emerging countries like India !

The NET effect of Debt on the WACC(Originally Posted: 08/25/2013)Hi,

I have a question regarding the NET effect of Debt in the WACC:

Onn the one hand, the Cost of Equity (Ke) increases as the company increases its D/E ratio because the BETA increases. This means that DEBT makes WACC higher.

On the other hand, the Cost of Debt (Kd) is smaller than Ke and there is also the thing of the savings because of the Tax Shield. So in this case DEBT makes WACC smaller.

Which is the net effect? I mean, It would depend on the Ke, Kd and Tax rate, but I have always seen that increasing the DEBT reduces the WACC, is that always true?

Thank you,

Jorge.

There are plenty of links you can find via Google that explain this rather well. Essentially, the value of the tax shield and lower cost of capital is beneficial to a certain threshold (i.e. the optimal capital structure). Debt beyond that point would become detrimental from a WACC perspective.

If you are a visual person:

I can't really add any more value than to echo what peinvestor said. Just know that WACC is a U-shaped curve, and you should be fine.

"You rarely have time for everything you want in this life, so you need to make choices. And hopefully your choices can come from a deep sense of who you are." - Mister Rogers

Cost of capital/WACC(Originally Posted: 11/14/2013)How do you guys determine the cost of capital or WACC in using DCF method to valuate the company?

Figuring out the rest of the stuff seems easy, is there a target cost of capital posted by the company? Or is there anything under MD&A?

Thanks.

You should be able to calculate it using the company's financial statements along with several different assumptions. Find the interest rates on their debt and calculate the weighted average across all debt sources. Use the CAPM to calculate their cost of equity, so risk free rate + Beta(market return - risk free rate) + unique risk associated w/ the company. Yahoo finance will have the 3 yr beta and just use the 10 yr risk free rate. Market return I think the normal is around 7%. Take the weighted average of the debt and equity cost and there ya go.

(CoE * CoE / (CoE+CoD)) + (CoD * CoD / (CoE+CoD)) * (1-taxrate)

WACC: (wd*rd)(1-TR) + (wps*rps) + (we*re)....look at the company's current K structure and compute. (Sec.gov, Bloomberg, etc.) Look at how much the average debt payment is for rd (raw estimate), check out FINRA's bond market data for issued debt. Calculate re for the firm based on a reliable metric, such as CAPM. If you're still having trouble check out thatswacc.com

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