Chapter 13: WAAC and company valuation

Question 1

How do firms compute weighted-average costs of capital? (LO13-1)

Answer 1

Here’s the WACC formula one more time:
WACC= [(D/V)×(1−Tc)r debt] + ((E/V)×r equity)

The WACC is the expected rate of return on the portfolio of debt and equity securities issued by the firm. The required rate of return on each security is weighted by its proportion of the firm’s total market value (not book value). Because interest payments reduce the firm’s income tax bill, the required rate of return on debt is measured after tax, as r debt × (1 − Tc).

Question 2

Why do firms compute weighted-average costs of capital? (LO13-2)

Answer 2

Firms need a standard discount rate for average-risk projects. An “average-risk” project is one that has the same risk as the firm’s existing operations and that supports the same rela- tive amount of debt.

Question 3

What about projects that are not average? (LO13-2)

Answer 3

The weighted-average cost of capital can still be used as a benchmark. The benchmark may be adjusted up for unusually risky projects and down for unusually safe ones.

Question 4

What happens when capital structure changes? (LO13-2)

Answer 4

The rates of return on debt and equity will change. For example, increasing the debt ratio will increase the risk borne by both debt and equity investors and cause them to demand higher returns. However, this does not necessarily mean that the overall WACC will increase because more weight is put on the cost of debt, which is less than the cost of equity. In fact, if we ignore taxes, the overall cost of capital will stay constant as the fractions of debt and equity change.

Question 5

How do firms measure capital structure? (LO13-3)

Answer 5

Capital structure is the proportion of each source of financing in total market value. The WACC formula is usually written assuming the firm’s capital structure includes just two classes of securities, debt and equity. If there is another class, say preferred stock, the formula expands to include it.

Question 6

How are the costs of debt and equity calculated? (LO13-4)

Answer 6

The cost of debt (r debt) is the market interest rate demanded by debtholders. In other words, it is the rate that the company would pay on new debt issued to finance its investment projects. The cost of preferred (r preferred) is just the preferred dividend divided by the market price of a preferred share.
The tricky part is estimating the cost of equity (r equity), the expected rate of return on the firm’s shares. Financial managers commonly use the capital asset pricing model to esti- mate expected return. But for mature, steady-growth companies, it can also make sense to use the constant-growth dividend discount model. Remember, estimates of expected return are less reliable for a single firm’s stock than for a sample of comparable-risk firms. There- fore, managers also consider WACCs calculated for industries.

Question 7

Can WACC be used to value an entire business? (LO13-5)

Answer 7

Just think of the business as a very large project. Forecast the business’s operating cash flows (after-tax profits plus depreciation), and subtract the future investments in plant and equipment and in net working capital. The resulting free cash flows can then be discounted back to the present at the weighted-average cost of capital. Of course, the cash flows from a company may stretch far into the future. Financial managers therefore typically produce detailed cash flows only up to some horizon date and then estimate the remaining value of the business at the horizon.