WACC WACC Calculation Calculation

WACC calculationWACC calculation  You have been just hired as a financial consultant by You have been just hired as a financial consultant by Harry Davis Industries. Your assignment is to estimate Harry Davis Industries. Your assignment is to estimate the firm's cost of capital. The CFO assembled the the firm's cost of capital. The CFO assembled the following information for you:following information for you:

1. The firm's marginal tax rate is 40 percent.2. The firm has outstanding an issue of 8 percent, semiannual coupon,

$1,000 par value bonds with 10 years remaining to maturity. They sell at a price of $1,148.77. New bonds will be privately placed with no flotation cost.

3. The current price of the firm's perpetual preferred stock (8 percent, $100 par value) is $114.29. New perpetual preferred stock could be sold to the public at this price, but Davis would incur flotation costs of 5%.

4. The firm's common stock is currently selling at $50 per share. Its last dividend was $3, and investors expect the dividend to grow at a constant 4 percent annual rate into the foreseeable future. The firm's beta is 1; the current yield on T-bonds is 5 percent; and the market risk premium is estimated at 6 percent. When using the firm's own bond-yield-plus-risk-premium approach, the managers assume a risk premium of 4 percentage points.

5. The firm's target capital structure is 40 percent long-term debt, 10 percent preferred stock, and 50 percent common equity.

PARTS OF THE QUESTIONPARTS OF THE QUESTIONA. Calculate the firm's component costs of debt.B. Calculate the firm's cost of preferred stock.C. Assume that the firm is using only retained earnings

as equity capital. Calculate the firm’s cost of retained earnings with the following three methods:

  Calculate the firm's estimated cost of retained earnings

based on the CAPM approach. Calculate the estimate of the firm's cost of retained

earnings based on the DCF approach. Calculate the firm's cost of retained earnings based on the

bond-yield-plus-risk premium approach.

D.Calculate the firm's weighted average cost of capital (WACC).

E. Assume that the firm used up all of its retaining earnings and it has to start issuing common stock with a flotation cost of 20 percent. What will its cost of common equity be?

LET’S SEE WHAT WE HAVE LET’S SEE WHAT WE HAVE ALREADYALREADY

1. -Marginal tax rate is 40%-Outstanding is 8%-Semiannual coupon-Par value of bonds $1,000 -Maturity is 10 years-Selling price is $1,148.77-No flotation cost.

2. -Perpetual preferred stock is $114.29 -Par value of bonds $100

  -Outstanding is 8%-Stock could be sold

3. -Common stock selling price is $50 per share  -Dividend is $3

-Expect the dividend to grow at a constant 4 percent annual rate into the foreseeable future.

  -Beta is 1  -T-bonds is 5%  -RPm is 6%  * own bond-yield-plus-risk-premium approach,

assume a risk premium of 4 percentage points.

4. -capital structure is;40% long-term debt, - Wd10% preferred stock, - Wps50% common equity. - Ws

 

NOW LET’S SEE THE NOW LET’S SEE THE QUESTIONS AGAINQUESTIONS AGAINA. Calculate the firm's component costs of debt.B. Calculate the firm's cost of preferred stock.C. Assume that the firm is using only retained earnings

as equity capital. Calculate the firm’s cost of retained earnings with the following three methods:

  Calculate the firm's estimated cost of retained earnings

based on the CAPM approach. Calculate the estimate of the firm's cost of retained

earnings based on the DCF approach. Calculate the firm's cost of retained earnings based on the

bond-yield-plus-risk premium approach.

D.Calculate the firm's weighted average cost of capital (WACC).

E. Assume that the firm used up all of its retaining earnings and it has to start issuing common stock with a flotation cost of 20 percent. What will its cost of common equity be?

**Capital ComponentsCapital ComponentsCapital components are sources

of funding that come from investors.

Accounts payable, accruals, and deferred taxes are not sources of funding that come from investors, so they are not included in the calculation of the cost of capital.

**Before-Tax vs. Before-Tax vs. After-Tax Capital CostsAfter-Tax Capital Costs

Firms should incorporate the tax effects in the cost of capital. They should focus on the after-tax costs.

Only the cost of debt is affected because interest is a tax-deductable expense.

A. Calculate the firm's component costs A. Calculate the firm's component costs of debt.of debt.

Since the bond is selling above par, the cost of debt is less than the coupon interest rate. The cost of debt is the discount rate that makes the bond's future cash flows (i.e., coupon interest and par value payments) equal to the market price of the bond. It is 3% semiannually and 6% annually. Therefore after tax cost of capital is:

Rd AT = rd BT(1 – T)0.036= 0.06(1-0.40)

B. Calculate the firm's cost of B. Calculate the firm's cost of preferred stock preferred stock

Cost of preferred stock: PCost of preferred stock: Ppsps = $11 = $114.294.29, , Div=Div=88%, Par = $100, F = 5%%, Par = $100, F = 5%

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formula:

Rps= Dps

Pps (1 – F)=

0.08 ($100)

$114.29 (1 – 0.05)

= $8

$108.57

= 0.074 = 7.4%

**Cost of Preferred StockCost of Preferred Stock

Flotation costs for preferred stock are significant, so are reflected. Use net price.

Preferred dividends are not tax deductible, so no tax adjustment.

Three ways to determine Three ways to determine the cost of retained the cost of retained

earningsearnings

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1. CAPM: rs = rRF + (rM – rRF) b

= rRF + (RPM) b

2. DCF: rs = D1/P0 + g

3. Own-Bond-Yield + Judgmental Risk Premium: rs = rd + JRP

**What are the two ways that What are the two ways that companies can raise companies can raise common equitycommon equity??

•By retaining earnings that are not paid out as dividends.

•By issuing new shares of common stock.

**Cost for Retained Cost for Retained EarningsEarningsOpportunity cost: The return

stockholders could earn on alternative investments of equal risk.

They could buy similar stocks and earn rs, or company could repurchase its own stock and earn rs. So, rs, is the cost of reinvested earnings and it is the cost of common equity.

C. Assume that the firm is using only retained C. Assume that the firm is using only retained earnings as equity capital. Calculate the firm's earnings as equity capital. Calculate the firm's estimated cost of retained earnings based on the estimated cost of retained earnings based on the CAPM approach.CAPM approach.

Rs = Rrf + (RPm)b 

Rs = 4% + 6%.1 = 10%

C. Calculate the estimate of the firm's cost C. Calculate the estimate of the firm's cost of retained earnings based on the DCF of retained earnings based on the DCF approach.approach.

• Rs = [D0 * (1+g)] / P0 + g

• Rs = 3 * (1.04) / 50 + 0.04 = 0.1024

C. C. Calculate the firm's cost of retained Calculate the firm's cost of retained earnings based on the bond-yield-plus-earnings based on the bond-yield-plus-risk premium approach.risk premium approach.

the own bond yield is 6%. The risk premium is given as 4%. Therefore, the cost of retained earnings with the third method is:

6%+4%=10%

**Comparing Comparing and Awerage of and Awerage of the Three Methodsthe Three MethodsIn practice, most firms use the

CAPM to estimate the cost of equity capital.

Many firms use the DCF method.

Some firms estimate the cost of equity capital by adding a risk premium to their bond interest rate.

Brigham and Ehrhardt suggest that the average of the three methods can be used in estimating the cost of equity capital.

What’s a reasonable final What’s a reasonable final estimate of restimate of rss??

Method Estimate

CAPM 10.24%

DCF 10%

rd + JRP 10%

Average 10.08%

Awerage of the three Awerage of the three methods;methods;

The cost of equity capital with the retained earnings is the average of the three methods:

10.24%+10%+10%=10.08%

**Determining the Weights for Determining the Weights for the WACCthe WACCThe weights are the percentages

of the firm that will be financed by each component.

If possible, always use the target weights for the percentages of the firm that will be financed with the various types of capital.

**Estimating Weights for the Estimating Weights for the Capital StructureCapital Structure

If you don’t know the targets, it is better to estimate the weights using current market values than current book values.

If you don’t know the market value of debt, then it is usually reasonable to use the book values of debt, especially if the debt is short-term.

**What factors influence a What factors influence a company’s WACC?company’s WACC?

Uncontrollable factors:

◦ Market conditions, especially interest rates.◦ The market risk premium.◦ Tax rates.

Controllable factors:

◦ Capital structure policy.◦ Dividend policy.◦ Investment policy. Firms with riskier

projects generally have a higher cost of equity.

D.Calculate the firm's weighted D.Calculate the firm's weighted average cost of capital (WACC).average cost of capital (WACC).

WACC = wd rd (1 – T) + wps rps + ws rs

= 0.4 (0.036) + 0.1 (0.074)+ 0.5 (0.108)

= 0.0758 ≈ 7.58%

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**Is the firm’s WACC correct Is the firm’s WACC correct for each of its divisions?for each of its divisions?

No! The composite WACC reflects the risk of an average project undertaken by the firm.

Different divisions may have different risks. The division’s WACC should be adjusted to reflect the division’s risk and capital structure.

E.Assume that the firm used up all of its retaining E.Assume that the firm used up all of its retaining earnings and it has to start issuing common stock earnings and it has to start issuing common stock with a flotation cost of 20 percent. What will its cost with a flotation cost of 20 percent. What will its cost of common equity be?of common equity be?

Re = [ D0 * (1+ g) ] / [P0 * (1-F) ] + g

 Re = [3 * ( 1+0.04) ] / [ 50 * ( 1-

0.2)] + 0.04 = 0.118