17.3 Calculating the Weighted Average Cost of Capital

The weighted average cost of capital (WACC) is a crucial concept in finance that measures a company's overall cost of financing. It considers the mix of debt and equity used to fund operations, weighing each source's cost by its proportion in the capital structure.

Calculating WACC involves several methods for estimating equity costs, including the Capital Asset Pricing Model and Dividend Discount Model. Understanding net debt's impact on WACC and the relationship between financial leverage and opportunity cost is essential for making informed financial decisions.

Weighted Average Cost of Capital (WACC)

Calculation of weighted average cost of capital

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• WACC represents the overall cost of financing a company's assets by considering the proportions and costs of debt and equity financing (loans, bonds, common stock, preferred stock)
• Formula: $WACC = w_d r_d (1 - t) + w_e r_e$
  • $w_d$: proportion of debt in the capital structure indicates the percentage of financing from debt sources
  • $r_d$: cost of debt reflects the yield to maturity on existing debt or current market rates for new debt issuance
  • $t$: marginal tax rate accounts for the tax deductibility of interest expenses, which reduces the effective cost of debt (after-tax cost of debt)
  • $w_e$: proportion of equity in the capital structure indicates the percentage of financing from equity sources
  • $r_e$: cost of equity represents the required rate of return for equity investors based on the risk they bear
• Debt is typically cheaper than equity due to tax deductibility of interest, which lowers the effective cost, and lower risk as debt holders have priority claims on assets and income
• Equity is more expensive than debt due to higher risk borne by equity holders, who are residual claimants, and lack of tax benefits associated with equity financing
• Changes in capital structure affect WACC, as increasing debt generally lowers WACC up to a point, as debt is cheaper than equity, but excessive debt increases financial risk and can raise both debt and equity costs (interest rates, required returns)
• The target capital structure influences the WACC calculation by determining the optimal mix of debt and equity financing

Methods for estimating equity capital cost

• Capital Asset Pricing Model (CAPM) estimates the cost of equity based on the stock's sensitivity to market risk
  • Formula: $r_e = r_f + \beta (r_m - r_f)$
    • $r_f$: risk-free rate represents the return on a theoretically risk-free investment (government bonds)
    • $\beta$: beta coefficient measures the stock's systematic risk relative to the market (S&P 500 index)
    • $r_m$: expected market return is the average return expected from the broad market portfolio
  • Assumes investors are well-diversified and only require compensation for systematic risk that cannot be diversified away
  • Limitations: relies on historical data to estimate beta and market risk premium, assumes market efficiency, and requires subjective estimates of the expected market return
• Dividend Discount Model (DDM) calculates the cost of equity based on expected future dividends and stock price
  • Formula: $r_e = \frac{D_1}{P_0} + g$
    • $D_1$: expected dividend per share in the next period based on the company's dividend policy
    • $P_0$: current stock price observed in the market
    • $g$: expected dividend growth rate assuming constant growth, estimated using historical data or analyst projections
  • Assumes that the value of a stock equals the present value of its future dividends discounted at the cost of equity
  • Limitations: requires estimating future dividends and growth rates, which are uncertain, and not suitable for non-dividend-paying stocks (startups, growth companies)
• Bond Yield Plus Risk Premium (BYPRP) method estimates the cost of equity by adding a risk premium to the company's long-term debt yield
  • Formula: $r_e = Y_d + RP$
    • $Y_d$: yield on the company's long-term debt reflects the current cost of borrowing
    • $RP$: equity risk premium is a subjective estimate of the additional return required by equity investors over debt
  • Limitations: risk premium is subjective and may not accurately reflect the true risk differential between the company's debt and equity

Net debt's impact on WACC

• Net debt is total debt minus cash and cash equivalents, representing the amount of debt that would remain if the company used all its cash to repay debt (loans, bonds)
• When calculating WACC, use net debt instead of total debt in the capital structure to adjust for the fact that cash can be used to repay debt, reducing financial risk
• Higher net debt increases financial risk and can raise both debt and equity costs, leading to a higher WACC (interest rates, required returns)
• Lower net debt reduces financial risk and can lower both debt and equity costs, leading to a lower WACC
• Changes in net debt can affect investment and financing decisions:
  1. Projects that increase net debt may become less attractive due to a higher WACC, making them less likely to be pursued
  2. Financing decisions that reduce net debt, such as issuing equity or using cash to repay debt, may lower WACC and make more projects viable by reducing the hurdle rate for investment

Financial leverage and opportunity cost

• Financial leverage refers to the use of debt to finance a company's operations and affects the WACC through its impact on the capital structure
• Opportunity cost in WACC represents the return investors could earn on alternative investments with similar risk profiles
• The weighted average nature of WACC accounts for the different costs and proportions of various financing sources