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WACC Module 1

The document discusses the weighted average cost of capital (WACC). It defines WACC as the cost of obtaining funds, primarily for investing activities. It then explains the corporate finance decision process and how WACC is used in capital budgeting and valuation. The document provides the formula for calculating WACC and discusses capital structure and how it impacts WACC. It also provides an example calculation and illustration.

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Jay Aubrey Pineda
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214 views10 pages

WACC Module 1

The document discusses the weighted average cost of capital (WACC). It defines WACC as the cost of obtaining funds, primarily for investing activities. It then explains the corporate finance decision process and how WACC is used in capital budgeting and valuation. The document provides the formula for calculating WACC and discusses capital structure and how it impacts WACC. It also provides an example calculation and illustration.

Uploaded by

Jay Aubrey Pineda
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Module 1

Weighted Average Cost of


Capital (WACC)

Introduction
Decision Process
Importance of WACC
WACC and Capital Budgeting
WACC Formula
Capital Structure
5-1
Introduction

Cost of obtaining funds;


Primarily for investing activities.

5-2
Decision Process

Personal Finance: Financing, Investing,


Operating;
Corporate Finance:
> Investing (Look);
> Financing (WACC determination);
> Investing (Accept?);
> Financing (Raise funds);
Cash
> Investing (Expenditure); Flows
> Operating (Day-to-day)

5-3
Importance (Use) of WACC

1. Capital Budgeting (NPV,IRR);


2. Valuation of Stocks (CVM);
3. Valuation for Mergers/Acquisitions (DCF).

5-4
WACC and Capital Budgeting

A = D + E;
Rate of return of A vs. Cost of Capital
(WACC) of D + E; this is IRR;
Benefits (PV of CFs using Cost of Capital, or
WACC, as discount rate) vs Cost investment
(in A); this is NPV.

5-5
WACC Formula
WACC
= [Wd x rd (1-tax rate)] + (Wp x rp) + (Wc x rs)
= [(D/V) x rd (1- tax rate)] + [(C/V) x rs] + [(P/V) x rp]
Wd = weight of debt; Wp = weight of PS; Wc = weight of
CS
D = Value(MV) of debt; P = Value(MV) of PS;
C = Value (MV) of CS
Rd = return on debt; interest rate;
rd(1-tax rate) = after-tax cost of debt
rp = return or cost of preferred stock;
rs = return or cost of equity; RE (internal equity);
re = return or cost of new CS (external equity)
5-6
WACC Formula

Sample illustration
Given:
D = P15M, C = P25M, P = P10M; rd = 5%, rp = 10%,
rs = 15%, tax rate = 30%
Solution:
= 30% x 5%(1-30%)+ 20%x10% + 50% x 15%
= 10.55%

5-7
Capital Structure

Proportion of debt, PS and CS;


Optimal Capital Structure (OCS): maximize shareholder
wealth (maximize stock price) and minimize WACC;
Basis: Using DDM, higher stock price, lower rs,
lower WACC; Using CVM, lower WACC, higher MV of Firm,
higher MV of Equity, higher stock price;
Current capital structure: based on BS; same with OCS? can
be the OCS?

5-8
Capital Structure
Hierarchy of amounts: 1) Target; 2) Market Value (Equity =
Shares x Stock Price; Debt = PV of CFs using DCF);
3) Book Value (PS = Par Value; CS = Par Value, APIC/Share
premium, RE; Debt = LT debt in the books
Inclusion: LT sources; investor supplied funds;
Exclusion: CL such as AP and accruals (not investor
supplied);
Other CL: ST interest-bearing note and current portion of LT
debt (included accdg to Brigham);
ST debt used to finance LT investment, ST debt rolled
over and becomes permanent (included accdg to Brealy);
Other CL (excluded accdg to Gitman; CL in general are
excluded) 5-9
Illustration

Question: Theory 10-3, page 359;


Answer: Use 1st - target capital structure, 2nd MVs, 3rd
BVs
Question: Problem 10-9, page 360;
Solution:
> D = P1,152, C = 576 shares x P4 = P2,304
> V = P1,152 + P2,304 = P3,456
> Wd = P1,152/P3,456 = 33.33%;
Wc = P2,304/P3,456 = 66.67%
> WACC = [13% x (1-40%) x 33.33%]
+ (16% x 66.67%)
= 13.27%
5-10

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