Weighted Average Cost of Capital (WACC) — Transcript

Full transcript

1. 0:00weighted average cost of capital in this
2. 0:04session we're gonna estimate the cost of
3. 0:07capital it consists of equity funding
4. 0:10cost and debt funding cost and then we
5. 0:13weight those two based on the capital
6. 0:15structure of the company the combined
7. 0:18cost is the weighted average cost of
8. 0:20capital which is the cost of funding the
9. 0:23assets of the company let's look at a
10. 0:26breakdown of how this works let's take
11. 0:29the weighted average cost of capital for
12. 0:31a company and break it down into its
13. 0:34various components the first distinction
14. 0:37is separating the weighted average cost
15. 0:39of capital into the cost of equity and
16. 0:42the cost of debt and you can see as the
17. 0:46representation here shows that they will
18. 0:48be weighted depending on how much of the
19. 0:50company's capital consists of equity and
20. 0:52how much of the company's capital
21. 0:54consists of debt let's start on the
22. 0:57equity side we're gonna begin by taking
23. 0:59the risk-free rate the risk-free rate is
24. 1:02typically a 10-year government bond it's
25. 1:05considered to be risk-free because if
26. 1:07the government were in a position to
27. 1:09default it could technically print the
28. 1:11money and therefore not default and is
29. 1:14hence risk-free next we're gonna add to
30. 1:18that the beta of the stock multiplied by
31. 1:25the equity risk premium in that country
32. 1:27so for example we would look back at two
33. 1:31years of the stock price volatility on a
34. 1:34weekly basis we would take the
35. 1:36volatility of return and determine what
36. 1:39the beta is suppose the beta was one
37. 1:42that means the company has the same
38. 1:44volatility as the market and we would
39. 1:46multiply one by the equity risk premium
40. 1:49let's say it's in the United States and
41. 1:51the equity risk premium there is 6% then
42. 1:55it would be 1 times 6 if the beta were 2
43. 1:58meaning twice as volatile as the market
44. 2:00it would be 2 times 6 which is 12% you
45. 2:04would take that and add it to the
46. 2:06risk-free rate suppose that's 2% then
47. 2:09you would have your total cost of equity
48. 2:14the debt side of things it's a little
49. 2:16simpler you can take the average yield
50. 2:18on the debt of the company and then
51. 2:21multiply it by one minus the tax rate
52. 2:24because there is the tax deductibility
53. 2:26of interest but there is no tax
54. 2:29deductibility of anything on the equity
55. 2:32side if the company doesn't have public
56. 2:34debt or any debt that has an observable
57. 2:38yield you can look at a similar company
58. 2:40that you believe would have a similar
59. 2:42credit rating and assess their cost of
60. 2:44debt so we get the cost of debt after
61. 2:49tax we then multiply the cost of equity
62. 2:53by the proportion of capital that's
63. 2:56equity and we multiply the cost of debt
64. 2:59by the proportion of capital its debt
65. 3:00and at the end we get the weighted
66. 3:03average cost of capital for the company
67. 3:06let's work through a couple examples of
68. 3:09calculating firms weighted average cost
69. 3:12of capital as a refresher the whack
70. 3:14formula is equal to the cost of equity
71. 3:17multiplied by the proportion of capital
72. 3:20that's in equity plus the cost of debt
73. 3:23after tax multiplied by the proportion
74. 3:25of capital coming from debt so the cost
75. 3:30of equity is equal to the risk-free rate
76. 3:32plus the beta times the market risk
77. 3:35premium equity is valued as being the
78. 3:40proportion of equity capital relative to
79. 3:43the total capital of the business and
80. 3:45the debt is the same thing the
81. 3:47proportion of debt relative to the total
82. 3:49capital and then the after-tax cost of
83. 3:52debt is the yield of debt multiplied by
84. 3:54one minus the tax rate so here's our
85. 3:57formula as a refresher so here's the
86. 4:01information you've been provided for
87. 4:03enternet co and we want you to calculate
88. 4:05the cost of equity the risk-free rate is
89. 4:085% the market risk premium is 4% and the
90. 4:13beta is two point three eight calculate
91. 4:17the equity return required by
92. 4:19shareholders of Internet Co please try
93. 4:22this on your own and we'll show you the
94. 4:24example
95. 4:28so here's a breakdown of the solution
96. 4:30we're gonna break this down into simple
97. 4:32steps showing the required rate of
98. 4:35return
99. 4:35it's the risk-free rate plus the beta
100. 4:38times the market risk premium the
101. 4:42risk-free rate is 5 the beta is 2.38
102. 4:45the premiums 4% we multiply that out we
103. 4:50get 9.5 2 percent on the equity premium
104. 4:53side and 5% on the risk-free rate so the
105. 4:57cost of equity for Internet Co is 14.5
106. 5:012% now that we've seen how to calculate
107. 5:04the cost of equity let's move on to
108. 5:07another example where we'll calculate
109. 5:08the weighted average cost of capital so
110. 5:11consider a different company
111. 5:13brick-and-mortar Co it has a cost of
112. 5:16debt of 10% cost of equity of 15% a 30
113. 5:21percent tax rate 10 million of debt and
114. 5:2540 million of equity so what is the
115. 5:29whack for brick and mortar Co please try
116. 5:32this on your own and then look at the
117. 5:34example solution we're going to break
118. 5:38down the whack calculation into 4 steps
119. 5:40here the first step is to fill in all
120. 5:46the numbers where we need the proportion
121. 5:48of equity and the cost of equity plus
122. 5:51the proportion of debt and the after-tax
123. 5:53cost of debt so here are all the numbers
124. 5:56that go in our equation that breaks down
125. 5:59to be an 80% equity structure at 15%
126. 6:04cost and a 20% debt structure at 7
127. 6:08percent after-tax cost we can combine
128. 6:12that to be 12 percent on the equity side
129. 6:15and 1.4 percent on the debt side after
130. 6:19weighting them and combining that to get
131. 6:2213.4% weighted average cost of capital
132. 6:25for brick-and-mortar co