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Formulas involved on the WACC calculations

Corporate Finance - MBA 2009
Note written by Prof. Carles Vergara-Alert & Prof. Pedro Saf

1 Objective
This note tries to clarify the different assumptions and formulas used to calculate the Weighted Average Cost Of Capital (WACC) that you will nd in different textbooks and articles.

2 The WACC formula

The WACC formula is a weigthed average of the cost of equity and the after-tax cost of debt: W ACC = E D+E RE + D D+E (1 )RD (1)

being RE the cost of equity, RD the cost of debt, the corporate tax, E the market value of the rms equity, and D the market value of the rms debt. Note that sometimes we call V to the sum of D and E, therefore, V = D + E. Sometimes, not all the nancing is provided by debt and equity. As an example, let us assume that some nancing is provided by preferred stock as well as equity and debt. The WACC formula has to be modied to include the main sources of long-term nancing of the rm such as preferred stock: W ACC = E D P RE + (1 )RD + RP D+E+P D+E+P D+E+P

where RP is the cost of preferred stock and P is the market value of the rms preferred stock.

3 Using the WACC formula

It is straightforward to obtain most of the values for the variables in the WACC formula (lets focus on formula (1) from now on): The market value of the rms equity (E) can be simply estimated as the value of the rms shares times the number of shares. The book value of the rms debt can be used as a proxy for the market value of the rms debt (D). The corporate tax rate is given (ex. = 34% can be used as a proxy for federal tax rate in the US). The cost of debt RD should reect the reality of the company. Each company knows its debt rate premium that they will have to pay for their debt, that is, it knows the spread over the treasury that lenders will require to lend capital to this particular rm1 ); therefore, RD = RF + Companys debt premium where RF is the current risk-free interest rate with maturity similar to the projects that we want to consider.
1 This is equivalent of saying, for example, that you know how many basis points over the LIBOR the banks will charge you if you borrow from them (e.g. if you get a mortgage). Obviously, it is easy to obtain the value of the spread over the treasury that they will charge you: you just have to ask a few banks.

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However, we need to do a little bit of work to calculate the cost of equity RE under a different leverage ratio (D/V ) than the one from which the original equity was computed from. In general, we will follow two steps to calculate RE . Firstly, we must unlever E . Knowing the equity beta (E ) of the rm2 and the debt beta (D ) of the rm3 , it is straigthforward to compute the asset beta (A ) using the following formula: A = D E E + D . D+E D+E (2)

Secondly, we must relever E . Note that A is a measure of risk of the assets of the rm that allow us to compute RA using the CAPM formula: RA = RF + A (RM RF ). The return on assets (RA ) is return required by the investors to bear just the operational risk of the company, i.e., after we strip out the effects from leverage. Now we are ready to calculate the cost of equity RE using the following formula: D (RA RD ). (3) E We have calculated the numbers for all the variables involved in the WACC formula: E, D, , RD and RE . RE = RA +

4 Assumptions on the target debt behind the formulas

Equations (1), (2) and (3) and the CAPM equation are the only formulas that we need to calculate the WACC. We should stress that we have made an important assumption in equations (2) and (3): The rm has a target debt ratio D/V (in contrast to the rm has a target debt level D). Where does equation (3) come from? It comes from the necessary equilibrium among assets, debt and equity in the balance sheet: D E RE + RD . (4) RA = D+E D+E If we solve equation (4) for RE , then we obtain equation (3). Note also that if we apply the CAPM formula to RA , RE and RD in equation (4), then we will obtain equation (2). Note that most companies present a target debt ratio D/V rather than a target debt level D. The reason is very simple: the rm may get bigger and a target debt level D does not make sense in the medium or long run. Therefore, some books and articles use the formulas based on the assumption that the rm has a target debt level D. The equivalent formulas to (2), (3) and (4) when we make this assumption are the following: A = E D(1 ) E + D . D(1 ) + E D(1 ) + E D (1 )(RA RD ). E (5) (6) (7)

RE = RA + RA =

E D(1 ) RE + RD . D(1 ) + E D(1 ) + E

2 We know from the nancial markets. We can obtain it from a data provider (e.g. Bloomberg, Datastream) or calculate it ourselves E (as we did in the Ameritrade case). 3 It can be easily estimated using the CAPM formula, R R = (R D F D M RF ), and solving for D

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5 Conclusions
Two main conclusions arise from this note. First, you should always use the two-step method (step 1: unlevering E ; step 2: relevering E ) in order to calculate the cost of equity RE to be used in the WACC formula. This should be done whenever the company has a different leverage ratio than the one used to compute the equity we started up with. This initial equity beta might be different because the company is planning to change its capital structure (like Marriot wanted to change its leverage to a new target ratio), or because the betas are coming from comparable rms that have different leverage ratios as well (like the comparables we had to use when estimating the divisional betas of Marriott). Second, most rms have a target debt ratio D/V rather than a target debt level D. Therefore, equations (2) and (3) should be the ones used in most of the WACC calculations.