# Finance Theory and Practice

Finance Theory and Practice

FIN 430 — Finance Theory and Practice
Project Assignments
Calculating the Weighted Average Cost of Capital (WACC)

For use in Conjunction with the Firm Valuation Project

First ensure that you have read relevant pages in the text. Some important sections would include the following, but you may also double-check the references in the text by using the index [see: Cost of Capital and Target (optimal) Capital Structure, etc.]:

The important Chapter in the text is the one entitled “The Cost of Capital,” – with a particular focus on the section entitled “The Weighted Average Cost of Capital” and the section “Four Mistakes to Avoid” at the end of the chapter.

The WACC formula discussed below does not include Preferred Stock. Should your company use PS, be sure to adjust the equation for it, and see the section in the chapter on the Cost of Preferred Stock.

The WACC formula that we use is:

WACC = wdrd(1-T) + wsrs

We need to know how to calculate:

1. rs the cost of common equity. Use the Security Market Line (SML) – this is why you learn how to calculate a company’s beta and also why you learn how to find the appropriate risk-free rate and market-risk premium. For a review, see the section the text, The CAPM Approach.
2. The weights (wd and ws – note that: wd + ws = 1; so you only have to calculate one of them). We need to calculate the weight of debt and the weight of equity (for the cost of debt, this simply means: what proportion of the firm’s financing is by debt?). There is a lot to say here, simplified as Theory 1, Theory 2 and Practice:

a. Theory 1 : Theory says that we should use the target weights along with the market values of both debt and equity (see the Four Mistakes to Avoid ). But the market value of debt is typically difficult to calculate, because we need to know the YTM (which is rd) for all of the company’s debt, but we cannot calculate the YTM without having the current prices of the company’s outstanding bonds, and most company’s bonds do not trade (i.e., they will not have up-to-date or current prices – remember how to calculate the price (value) of a bond on your calculators?!). As a result, at least for the group project, we go to Theory 2.

b. Theory 2 : Theory also says that we should use the TARGET weights, but this is a management decision, and as “outsiders” we do not have access to the thoughts of the CFO or CEO. So we should look instead to the historical pattern of the use of debt (mix of debt and equity), and this is one reason that you should have about 10 years of financial data.

c. Practice: Since we cannot “work” according to the strict theory of finance, we have to estimate the relevant weights. As a result, we will use the formula: wd = Book Value of Debt / [Market Value of Equity + Book Value of Debt] The book value of debt is calculated by adding up ALL of the debt on the balance sheet. This will typically be the sum of Notes Payable, Current Portion of LT Debt and Long-Term Debt. The market value of equity is the “Market Cap,” and equals the number of (common) shares outstanding multiplied by the price/share. Note that the “timing” of this value should coincide with the book value of debt. For example, if you calculate the book value of debt as of 12/31/17, then the market cap should also be calculated for that date. Be very careful about using the reported Market Cap on Yahoo.finance – it may not have the same “timing.”

Another simple way is to look at the average cost of debt for the firm: Pre-tax cost of debt = annual interest payment / total interest-bearing debt. Please use the average cost for last three years.

1. The corporate tax rate ( T ). Be sure to read the section in the text on Corporate Income Taxes (Chapter 2). The correct tax rate for a company is the marginal tax rate for the future! If you expect your company to be very profitable for a long time into the future, then the tax rate ( T ) for your company should probably be the highest marginal tax rate applicable for corporations. But there are times when companies can obtain long-term tax breaks so that their tax rates may be lower than the stated (regulated) tax rate. Consequently you may want to calculate several/many historical effective tax rates for you company. The effective tax rate is the actual taxes paid divided by earnings before taxes (on the income statement). You can calculate/consider these rates for the past 5-10 years and then compare this effective tax rate to the legally mandated highest marginal corporate tax rate. If the past historical effective rate is lower than the marginal tax rate, there may be a good reason for using that lower rate in your pro formas.
2. r cs; the cost of common stock

You can use CAPM model to predict the cost of common stock. The equation runs as followings:

ri = rRF + (RPM) bi

In order to use this model, first you should estimate the beta of your stock. Please refer to the guidelines of beta calculation for more information. Please use the average 10 year Treasury bond rates as the proxy of risk-free rates.

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