Discount Rates and WACC Flashcards
How do you calculate WACC?
WACC = Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 – Tax Rate) + Cost of Preferred * (% Preferred)
For CoE, you can use the capital asset pricing model, and for others usually look at comparable companies and comparable debt issuances and interest rates + yields issued by similar companies to get estimates.
How do you calculate Cost of Equity?
Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta
Risk free rate represents how much an equivalent safe government bond should yield
Beta is calculated based on riskiness of comparable comps
Equity risk premium is the % by which stocks are expected to outperform risk-less assets like US treasuries.
Cost of Equity tells us the return that an equity investor might expect for investing in a given company – but what about dividends? Shouldn’t we factor dividend yield into the formula?
Dividend yields are already factored into beta as beta describes returns in excess of the market as a whole, which includes dividends.
How can we calculate Cost of Equity WITHOUT using CAPM?
Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends
This is less common than the “standard” formula but sometimes you use it when the company is guaranteed to issue Dividends (e.g. Utilities companies) and/or information on Beta is unreliable.
How do you calculate Beta in the Cost of Equity calculation?
Firstly dont have to calculate, could just use historical beta based on stock performance vs relevant index.
- look up beta for each comparable comp, un-lever each one, take the median of the set and then lever that median based on the company’s capital structure. Then use this levered beta in the CoE calculation
Unlevered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Total Debt/Equity)))
• Levered Beta = Unlevered Beta x (1 + ((1 - Tax Rate) x (Total Debt/Equity)))
Why do you have to un-lever and re-lever Beta when you calculate it based on the comps?
Betas found will already be levered because a companies previous stock price movements reflect the debt they’ve taken on, but each company capital structure is different so we wanna see how risky regardless of % debt n equity.
- so Unlever to find inherent business risk
Wait a second, would you still use Levered Beta with Unlevered Free Cash Flow? What’s the deal with that?
Yes, always use levered beta with cost of equity as debt makes stock riskier for everyone.
- use same CoE number for both LFCF where CoE is the DR
- also for UFCF, where CoE is a component of DR.
How do you treat Preferred Stock in the formulas above for Beta?
Should be counted as equity there as preferred dividends are not tax-deductible, unlike interest paid on debt.
Can Beta ever be negative? What would that mean?
Yes in theory, -1 beta means if market goes up 10%, asset goes down 10%
Would you expect a manufacturing company or a technology company to have a higher Beta?
Tech, as it is viewed as a more risky industry
Shouldn’t you use a company’s targeted capital structure rather than its current capital structure when calculating Beta and the Discount Rate?
Yes in theory, if you know it for sure then use it but this is rare.
The “cost” of Debt and Preferred Stock make intuitive sense because the company is paying for interest or for the Preferred Dividends. But what about the Cost of Equity? What is the company really paying?
2 ways:
- issues dividends to common shareholders
- gives up stock appreciation rights to other investors, so loses that upside.
. If a firm is losing money, do you still multiply the Cost of Debt by (1 – Tax Rate) in the WACC formula? How can a tax shield exist if they’re not even paying taxes?
Yes, as it doesn’t matter if debt is currently reducing company taxes, but whether there is potential for that to happen in the future.
How do you determine a firm’s Optimal Capital Structure? What does it mean?
Combination of Debt, Equity and Preferred Stock which minimises WACC.
- no mathematical solution
Let’s take a look at companies during the financial crisis (or really, just any type of crisis or economic downturn). Does WACC increase or decrease?
Cost of equity:
- risk free rate decrease, as gov drops IR
- ERP increase as investors demand higher returns before investing
- Beta would increase due to volatility, so overall CoE would increase.
WACC:
- Cost of debt and preferred stock both increase as it become more difficult for companies to borrow money
So WACC increases, as market discounts future cash flows at higher rates, so companies less valuable and WACC higher.
