WACC

Question 1

What is WACC?

Answer 1

Weighted Average Cost of Capital is the rate of return required by providers of finance. It is weighted to reflect the proportions of equity and debt in the capital structure.

Question 2

What is WACC used for?

Answer 2

It is used a discount rate in investment appraisal calculations.
And is used as hurdle rate for investments.

Question 3

How to calculate WACC?

Answer 3

It is an average of Ke and Kd.

• Cost of equity Ke= return required by investors
• Cost of debt Kd = return required by lenders.

The weighting is usually based on the market value of the equity and debt.

Question 4

Why is it important to minimise the cost of capital?

Answer 4

By minimising the cost of capital, the company maximises the market value of shares, assuming cash flows are unchanged.

Question 5

How is WACC minimised?

Answer 5

• Calculate the cost of each source

- Combine in optimal way

Question 6

Cost of ordinary shares/ equity

Answer 6

• Cost of equity (Ke) = Return on equity (Re)
• No tax effect
• CAPM is used to find Ke directly
• Dividend growth model finds Ke indirectly as a discount rate

Question 7

Cost of redeemable debt with a maturity date Kd

Answer 7

• Find Yield To Maturity
• YTM=Rd=Pre-tax Kd
• Need to adjust for tax

Question 8

Cost of irredeemable debt with no maturity date Kirr

Answer 8

• Valued using non-growing perpetuity formula
• r in formula =Rd= Pre-tax Kd
• Need to adjust for tax

Question 9

Cost of Equity- CAPM calculation

Answer 9

Required equity return

Ke= rf +(Beta*(rm-rf))

Question 10

Cost of Equity- DGM calculation

Answer 10

If we know the share price and dividend and g, we can indirectly find the required return.
Ke=r=(D1/Share price)+g

Question 11

Cost of debt

Answer 11

-The return to the bondholder is interest
-The interest is tax deductible for the company, which changes the cost to the company.
Rd= INT
Kd= INT*(1-t)

Question 12

Cost of debt calculation methods

Answer 12

The method depends on whether the debt is redeemable or irredeemable.
Redeemable: the IRR calculation required using after-tax interest
Irredeemable: a perpetuity and after-tax cost required

Question 13

Redeemable debt calculation

Answer 13

Map cash flows from debt

• interest: annual interest after tax (FV each year)
• principal: repaid at the end (FV in final year)
• market price of bond: Pv at time 0

Calculate YTM/IRR using IRR estimation

IRR= post-tax cost of debt to the company= post-tax Kd

Question 14

Irredeemable debt

Answer 14

Kd= (INT*(1-t))/MV

Kd= post-tax cost of debt
INT= interest paid= coupon * principal
t= tax rate
MV= market value of the irredeemable bond

Question 15

Tax shield

Answer 15

• important in making debt cheaper than equity
• can only be applied if the company is profitable
• if company is not profitable then it will not be paying tax and so cannot get tax relief on the interest payments
• if company is loss making it will not get the tax relied and so the cost to the company will equal the return to the bondholder

Question 16

Risk and the cost of capital

Answer 16

Equity is riskiest so should have the highest cost.

Preference shares

• Preference in dividend and on liquidation
• Lower cost than equity

Debt is less risky than shares

• Has preferential rights on liquidation
• May be secured
• Has tax shield
• Cost of debt will be lower than cost of preference or ordinary shares

Longer term debt will usually cost more than short term

Question 17

WACC Formula

Answer 17

WACC= Ke(E/E+D) +Kd(D/E+D)

Ke= cost of equity
Kd= cost of debt (post tax)
E= market value of equity 
D= market value of debt

Question 18

Problems with WACC

Answer 18

-Can only use market value to calculate cost of capital if the item has a market value i.e. is regularly traded.
Problematic for shares in private companies which are not traded.

• Should we include leasing? This is a source of long term finance
• Difficult to predict a dividend’s growth.

Question 19

WACC as project discount rte

Answer 19

It should only be used as a project discount rate if:
-Business risk is same (same industry)
-Financial risk same (same capital structure- gearing)
-If condition is not met:
Estimate WACC for project based on the project’s risk profile