1. Weighted Average Cost of Capital WACC Chapter - 12

2. Topic …. WACC ▪ Today’s Objective --- Learn how to calculate the “Weighted Average Cost of Capital” better known as WACC

3. What is WACC? ▪ The opportunity cost of “Capital” for taking on risk in an investment ▪ In it’s most simple form… ▪ Equity makes up $50 of the total capital stock (50%) ▪ Debt makes up $50 of the total capital stock (50%) ▪ Equity Investors require a 20% return on their investment ▪ Debt investors require a 10% return on their investment ▪ On average the company must payout (20+10)/2, or 15% ▪ If the company earns $1000 over the period, e.g., one year ▪ Debt Investors would get 10% x $1000 = $100 ▪ Equity Investors would get 20% x $1000 = $200 ▪ Or $1000 x 15% = $150 = ($100 +$200)/2 = $150

4. So… Where to do we use WACC? NPV = FCFF 1 / (1+ WACC ) 1 + FCFF 2 / (1+ WACC ) 2 … FCFF n / (1+ WACC ) n - (Initial costs) Gather Financial Facts for your Project (Business Case Information) NPV = FCFF 1 / (1+R) 1 + FCFF 2 / (1+R) 2 ….. FCFF n / (1+R) n - (Initial costs) Decision ---- IRR > R and NPV > 0 WACC = R Complete your Pro- forma Income and Cash Flow Analysis

5. Simple Steps for Calculating WACC ▪ Find the values for Debt, Equity and tax rate for your company - Internal: Financial Statements (balance sheet) - External: Publicly available data: 10k or secondary provider – S&P, Morningstar, etc. ( We will use Morningstar) ▪ Calculate the company’s “Market” Cost of Debt (Rd), i.e., what debt providers require as a return for loaning the company money. - Find the YTM of the company’s bonds ▪ Calculate the required return of Equity (Re) using the CAPM Model - Re = Rf + Beta(Risk Premium) ▪ Plug the values into the WACC equation

6. Generalized Formula for WACC ▪ WACC = E/V x Re + D/V x Rd(1-Tc) Where: E = Amount of Equity of the company D = Amount of Debt of the company V = Total of Debt and Equity Re = The percentage cost of equity Rd = The percentage cost of debt Tc = Tax rate If you have preferred Rp = Cost of preferred stock = (Preferred Dividend) / (Current Price of Stock) How do we derive the individual components of WACC….. E + D = V E = Equity D = Debt V = Total Capital e.g., E = 5 D = 5 V= 5 + 5 V = 10 E/V = 50% D/V = 50% Capital Structure Weights

7. “Capital Structure” Weights ▪ Use a trusted set of recent audited Financial Statements ▪ E + D = Total Capital ▪ Debt Capital ▪ Short Term Debt + Long Term Debt ▪ Equity Capital ▪ Price of the company’s stock x Number of shares outstanding E + D = V = Total Capital E = Market Value of Equity D = Market Value of Debt

8. Determining the Company’s Cost of Debt ▪ Rd = Cost of the company’s “Debt”. -Obtained from the YTM on the company’s outstanding bonds. -Remember YTM …… - Example: (10 year bond) (-$975 price) ($70 coupon) ($1000 Par value) 10 -$975 $70 $1,000 N I/Y PV (Price) PMT (Coupon) FV (Par Value) Solve for 7.36% Morningstar Morningstar and others (S&P, etc.) will have YTM on any publicly traded company

9. Cost of Equity ▪ Two ways to calculate “Cost of Equity” ▪ Dividend Growth Model & Capital Asset Pricing Model ( CAPM ) ▪ Dividend Growth Model ▪ P0 = D1 / (Re – g) which we can rearrange as ▪ Re = D1/P0 + g ▪ And…. D1 = (D0 + g) ▪ Problems with “Dividend Growth Model”… ▪ What if the company pays no dividends???? ▪ Will g always be constant….???? ▪ What about RISK ?

10. CAPM…… Cost of Equity ▪ Use the following information to compute the cost of equity ▪ Risk-free rate, R f (Treasuries….) ▪ Market risk premium, E(R m ) – R f ▪ Systematic risk of asset, , with the overall market, e.g., S&P 500 (Rm) ▪  e = Beta ▪ Standard & Poor's, Morningstar and Value Line provide betas for most domestic companies. ▪ CAPM  sigma…. Re = Rf = Beta (Risk Premium)

11. Example Best Buy’s WACC (BBY)

12. Your Turn ▪ Find a company from the S&P 500 and calculate the Beta for the stock. ▪ Online Guide -- Look at the WACC and Capital Structure Lecture: ▪ http://home.barton.edu/odrive/rlee/FIN301/pure-layout-side- menu/Lectures.html http://home.barton.edu/odrive/rlee/FIN301/pure-layout-side- menu/Lectures.html