# FIN500 Mod05 P3 Weighted average cost of capital (WACC)

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Hi this David at Bionic Turtle with an illustration of weighted average cost of capital;
we call that WACC. The other name for it is marginal cost of capital.
At the end also why it's important to keep in mind this is a marginal
cost of capital. And to illustrate I've got a hypothetical capital structure.
You can think, about the right hand side of the balance sheet
although that's book values, we try to use market values,
although in the case of debt we often times end up using
the book value as a proxy for the market value.
But I've got debt, preferred equity, and then equity
and then if I'm. I made some numbers up here: $300 million
is the value of the debt, so that might be the book value
but then we're going to just estimate that's the market value,
a good proxy for the market value, and then the preferred equity
of $100 million, and equity of $600 million;
for total of $1 billion. And then you can see I easily
calculate the weights. The debt of $300 million is 30%
of the total capital structure here of a billion.
So I have the weights for each the three components,
then my weighted average cost of capital, that's just the blended average
of the sources up these funds.
It's the rate of return that's required by the providers of the capital.
So in the case of debt its lenders that are provided the company capital.
In the case of equity it's the shareholders who have provided the capital.
So I have a blended average of the components, I already have their weights,
I just need each of their respective costs
to the company, or required rate of return
by the respective provider of capital.
So I have a cost for debt preferred,
and equity. In the case of debt, that's the interest rate.
I'm assuming 8%. Now the one difference with the debt is I
need an assumption for the corporate tax rate,
and that's because the debt provides a tax
shield to the company. Interest paid by the company reduces the
taxable income, gives the company a tax shield,
and makes this debt on an after tax basis cheaper.
So we use one minus tax rate
to incorporate that tax shield to the company, which lowers
converts the 8%t pre-tax into a lower effective after-tax cost to the company.
So you can see it there. A huge benefit
in terms of debt is a source of financing.
And then I have an assumption here for the preferred 10%.
So preferred is between debt and equity
although economically it's closer to debt,
but notice a key difference here - I'm not going to use the tax rate
because the company's not going to get a tax shield for the preferred dividends.
And then finally cost of equity, where
its common practice here, maybe not so modern,
certainly not very advanced, but common to use the capital asset pricing
model. Cost of equity here is risk-free rate plus
beta, which is the exposure to the common factor,
the market's equity risk premium.
So you can see here I've got an assumption about the risk-free rate of 4%,
the equity risk premium excess return on the market,
is 5%, so that means right here 4 plus 5 means that
we expect the overall market her 9%,
then I've got an assumption of beta of 1.6.
That's right here. And that means my cost of equity
for this company you can see I've got that formula in here
4% plus 1.6 beta
multiplied by the 5%
equity risk premium says to me the required rate return
to my shareholders who invest the equity, is 12%.
That's my cost of equity. Now you can see
if I go back to my weighted average cost of capital is just a blended average,
I have weights for each of the three components, and
I have the ability to calculate their cost, and in the case of
interest the interest rate it's going to be an effective after-tax cost,
after the tax shield. And so I just do that with this formula here
the result is 9.6 but you can see I've got the weight of debt,
30% multiplied by the cost of debt,
which is 8%
but multiplied by one minus tax rate of 40% so multiplied by 60%
and that's going to give me the convert the pre-tax 8% to an after-tax cost,
recognize the benefit of the tax shield,
so right there I've handled the debt component,
then I go to the preferred, that's more straightforward here
10% weight up here times
10% cost, and finally
I've got the equity component, the
60% weight multiplied by
the 12% cost of equity as assumed,
per the capital asset pricing model.
And that tells me my blended average, or weighted average,
is 9.6 and so that's how I calculate the weighted average cost of capital.
The final point, I want to go back to that idea this is a marginal cost of capital
because if you look at these costs, then you'll notice
after tax, the debt is the cheapest form of funding.
And so then, perhaps it occurs to you to ask the question
why wouldn't my company simply finance entirely with debt?
And to illustrate that you can see that I have a line here:
this line illustrates the weighted average cost of capital based on
how much of this capital structure has debt.
I've illustrated the example here at 30% debt
which corresponds to this point right here.
I don't know if you can see that, but that is that 30%
debt here on the x-axis, gives us the 9.6% weighted average cost of capital.
Now if I continue to use this model that's what I plotted here
and just if I swapped out equity and increased the share of debt,
in other words, if I leveraged up this company
then this is going to be linear - my weighted average cost of capital
in fact would go keep going down, down, down.
In which case if I just stuck to this model,
since debt has the lowest cost I would in fact go all the way to full leverage
if I wanted to minimize the weighted average cost of capital.
Yet companies aren't running around a 100% leveraged.
This model is actually incomplete and this gets back to the marginal idea,
because if in fact I did start to leverage,
increased amount of debt, then the cost financial distress
would need to start to enter into the equation.
Which is to say, that for one thing my lenders would start to chart a higher interest rate,
As my leverage gets higher
they're going to boost this up. In fact all of my providers are going to start
to charge a higher rate and some point they'd stop financing me
if the leverage was too great. And so here's a line that reflects that reality,
the cost of financial distress,
it's not a direct cost the bankruptcy but just the increased probability of
default. And that's illustrated by this line.
So there is such a thing as a theoretical optimal
weighted average cost of capital, but a balance is on the one
hand over here on the left, the fact that
equity is expensive, with over here on the right,
the fact that the greater the leverage the more we increase the cost of financial distress.
And so that goes back to what we put in here was for our current, or target, capital structure
and the 9.6 really represents incremental, or marginal, cost of capital
given this structure. As soon as we start to introduce new funds,
let's say new debt, and increase the leverage the company then this
actually dynamically stats to change; maybe more up towards here.
So it's not like this really operates at all levels, it a marginal cost of capital.
This is David Harper at the Bionic Turtle thanks for your time.
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