COMM 300: Weighted Average Cost of Capital

From BluWiki

EXAM QUESTION: How can equity holders possibly be happy when the firm is accepting projects with a 10% return and they WANT a 12% return. THEY ARE HAPPY, because the cost of debt is lower.

KNOW WEIGHTED AVERAGE COST OF CAPTIAL

Calculating

• Example:
  • 30% financing of debt @ 8% required return
  • 70% financing of equity @ .7% required return

WACC = Wd (Kd*) + Wo(Ko) + We(k) Kd* = after tax cost of debt Kd* = INTEREST(1-tax rate)

Note: basically, tax payers are paying for 40% of the interest expense, so they're basically funding the debt.

.3x8(1-.4)+.7(12)=9.84% < this should be the rate of return of capital budgeting projects of Average risk!

Calculating the weights

• Accounting way:
  • Add together all equity accounts (book values)
    • Common stock
    • Paid-in-capital
    • Retained earnings
  • For weighted equity: Divide total equity capital by total capital (usually long term debt + equity)
  • For weighted debt: divide total debt by total capital
• The finance way: calculate the market value of the debt & equity
  • NOTE: we just use the book value of the debt since it approximates the market value of the debt and it's easy to calculate
    • This is called enterprise value
    • For weighted equtiy: Mkt value of equity / (mkt value of equity + book value of the debt)
    • For weighted debt: book value of debt / (mkt value of equity + book value of the debt)

Calculating the costs

EVA (economic value added)

EVA = (ROIC - WACC) x invested capital

• There are three ways to make money:
  • Operating story
    • increase revenues or decrease costs): this would increase ROIC
  • Finance story
    • Reducing the WACC
  • Invested capital story
    • If ROIC < WACC, then reduce invested capital (stop the bleeding)!
    • If ROIC > WACC, then increase invested capital

Why is debt riskier than equity, and therefore the cost of debt lower?

• Fixed payments:" It's contractual
• Primary Claim: It stands "at the front" of the line.
  • Before
• Debt is tax deductible, while as equity is not.
  • Dividends are taxed, while interest payments are tax deductible