Comments (14)

May 14, 2010

thatswacc.com

May 14, 2010

^ nice

May 15, 2010

look up the 10k for GS

multiply the percent of equity financing by the CAPM

multiply the percent of debt financing by the YTM of a GS bond

add each together

May 15, 2010

By deciding to invest in Goldman, you have also decided NOT to invest in MS, Lazard, Citi, and other top publicly traded banks. So the opportunity cost that you use to discount GS's unlevered cash flows is the average of the unlevered returns for those companies.** The idea is that you at least have to exceed that return. Otherwise, why on earth did you invest in Goldman over the other guys?

**
1. regress daily equity returns over equity market returns to find company equity beta
2. Assume book value of debt = market value of debt (author edit)
3. plug betas and market values of debt and equity into WACC equation to find asset beta
4. average asset betas of all companies
5. plug average asset beta into CAPM to find the average unlevered return.

This unlevered return is the return you have given up the chance of earning by investing in Goldman. Thus it is your opportunity cost and your "cost of capital." Once you have this opportunity cost you can mess with the effect of leverage on equity returns, but the opportunity cost for the total stack of capital invested in GS will always be the number described above.

May 15, 2010

in other words, take the average of the peer group's unlevered betas, relever it using GS capital structure, insert into CAPM to find cost of equity.
for cost of debt, take average YTM of GS debt, multiply by (1-Tax Rate)

take weighed average of the two figures above= WACC

Free Consultation

Vantage Point MBA's clients are accepted to the top MBA programs at a 3x higher rate than the average acceptance rates. Request a consultation with their team to learn how they can help you gain admission to your dream schools. Learn more.

May 15, 2010

assume a debt beta of 0-.3. 1 is too high

May 15, 2010

Crap - you're right, rep. What I meant to say is assume that book value of debt equals market value of debt.

Affirmative, the opportunity cost is the return given up by not investing in the other companies. Explain to me how the YTM on Goldman's debt in any way affects the return for those other companies?

May 15, 2010
jhoratio:

Crap - you're right, rep. What I meant to say is assume that book value of debt equals market value of debt.

Affirmative, the opportunity cost is the return given up by not investing in the other companies. Explain to me how the YTM on Goldman's debt in any way affects the return for those other companies?

the way you calculate WACC, which is what the OP is asking, is by taking the weighted average of a company's cost of equity and cost of debt.

we aren't talking about how you, as an individual investor, would value what I am assuming would be direct investment in Goldman Sachs equity (as opposed to buying shares of multiple financial institutions)

May 15, 2010

i think the OP is trying to just get the basic WACC, cause hes prolly doing this for a class. (I am guessing that if he was doing this for a company, A: he would know how to calculate the WACC or he would already be fired).

good insight tho Jhoratio!

May 15, 2010
trailmix8:

i think the OP is trying to just get the basic WACC, cause hes prolly doing this for a class. (I am guessing that if he was doing this for a company, A: he would know how to calculate the WACC or he would already be fired).

good insight tho Jhoratio!

this is my thinking on Jhoratio's opportunity cost theory/method:

I feel that it's appropriate for use as a hurdle rate in IRR calculations, but not as a discount rate for NPV (present value of firm/equity)calculations.

to illustrate why, if we determine the opportunity cost of not investing in Lazard or Citi to be 12%, we would have to expect a return of at least 13% on Goldman Sachs (or else we would be indifferent between the investments). However, if we use this 13% as the discount rate in our DCF to value the Goldman Sachs equity, it will yield a lower present value than would 12%, implying that GS equity is riskier and less valuable.

it does work if we use the 12% as an IRR hurdle rate which the GS cash flows must surpass. If the IRR is greater than 12%, we invest in GS, if it is lower than 12%, we invest in Lazard or Citi.

Now, I am by no means an expert on financial theory and I may well be wrong, but this is the impression I got. Please correct if I'm wrong.

May 15, 2010

The discount rate and the opportunity cost are not two separate things. They are one and the same thing. You discount an investment (any investment) by its opportunity cost. The opportunity cost is the return given up by not investing in the next best thing.

The point of an NPV calculation is to determine the economic profit of an investment - that is, the return over and above what you'd expect to earn on a similar project with similar risks. If the opportunity cost of investing in GS is 12%, then you discount by 12% to find what marginal profit you earn (if any) by investing in GS. You don't arbitrarily tick the rate up by 100 bips and discount by that new rate.

The difference between an NPV calc and an IRR calc is this:

For NPV, you use the opportunity cost (discount rate) to come up with a dollar amount that represents the economic profit you make from your investment.

For IRR, you are trying to find the rate of return (NOT THE DISCOUNT RATE!!!) that makes the NPV you calculated above equal to zero.

So, say the opportunity cost for a GS investment is 12%. To find the NPV, you discount the GS cash flows by 12% and you end up with a dollar amount that represents your marginal profit.

To find the IRR of your GS investment, you just take that same exact calculation except you play around with the rate until the NPV is zero. The rate that does this is the IRR.

The discount rate and the IRR are not the same thing. Discount rate represents the risk, IRR represents the return. That is the entire idea behind the concept of an economic profit - to try to find the investment that, for a brief shining moment, will generate a return greater than the risk.

May 15, 2010
jhoratio:

The discount rate and the opportunity cost are not two separate things. They are one and the same thing. You discount an investment (any investment) by its opportunity cost. The opportunity cost is the return given up by not investing in the next best thing.

The point of an NPV calculation is to determine the economic profit of an investment - that is, the return over and above what you'd expect to earn on a similar project with similar risks. If the opportunity cost of investing in GS is 12%, then you discount by 12% to find what marginal profit you earn (if any) by investing in GS. You don't arbitrarily tick the rate up by 100 bips and discount by that new rate.

The difference between an NPV calc and an IRR calc is this:

For NPV, you use the opportunity cost (discount rate) to come up with a dollar amount that represents the economic profit you make from your investment.

For IRR, you are trying to find the rate of return (NOT THE DISCOUNT RATE!!!) that makes the NPV you calculated above equal to zero.

So, say the opportunity cost for a GS investment is 12%. To find the NPV, you discount the GS cash flows by 12% and you end up with a dollar amount that represents your marginal profit.

To find the IRR of your GS investment, you just take that same exact calculation except you play around with the rate until the NPV is zero. The rate that does this is the IRR.

The discount rate and the IRR are not the same thing. Discount rate represents the risk, IRR represents the return. That is the entire idea behind the concept of an economic profit - to try to find the investment that, for a brief shining moment, will generate a return greater than the risk.

Ok, I see your point about opportunity cost- discounting at the opportunity cost shows how much marginal profit you'll obtain. if the opportunity cost is higher, it means that the other investments (Lazard, Citi) have high returns, and GS cash flows will have to clear a higher hurdle in order to have residual profit. But it seems that this opportunity cost is an implicit IRR hurdle rate, as you need to at least match the opportunity cost (return on Lazard) to justify investing in GS

I guess what I'd like clarification on is using the discount rate for finding the present value of the firm's FCFF or FCFE. Using the opportunity cost as an NPV (invest/do not invest measure) discount rate makes sense, but it seems that it wouldn't make sense for a firm valuation as you need to use a CAPM-derived WACC discount rate based on the firm's risk/volatility relative to the market.

May 15, 2010

You are right about opportunity cost being just like a hurdle rate. You need to earn more than the opportunity cost otherwise the other investment is the 1st best thing, not the 2nd, and you destroyed value by picking the wrong horse.

WACC is very confusing name, because it sounds like you're averaging different "prices" to get an overall cost of capital when in fact it's just a breakout of the EXISTING OPPORTUNITY COST and how the individual components change with leverage. You're not adding things together to get a rate. You're starting with the rate and you break out the pieces. For discounting unlevered cash flows you should ALWAYS use the overall opportunity cost, aka the WACC (again a very confusing name for an opportunity cost). For discounting cash flows to equity you should use the cost of equity, which you can deterimine by using the WACC formula to break it out.

May 17, 2010
Comment