Chapter Three: Determining the Value of the Firm

This chapter shows how to apply the WACC to the valuation of firms and computation of the five
components of the WACC—the market value of the firm’s equity and debt E and D, the firm’s tax rate
TC, the firm’s cost of debt rD, and the cost of equity rE. We finish by showing detailed examples of how
to compute the firm’s WACC.
Calculating the Weighted Average Cost of Capital (WACC)
In discussing the WACC, we will recognize the fact that a firm will normally raise capital in a variety of
forms, which is called capital structure (specific mix of debt and ordinary equity) and, that these
different forms of capital may have different costs associated with them. These costs are called cost of
capital, which is the return that must be provided for the use of an investor’s funds. If the funds are
borrowed, the cost is related to the interest that must be paid to creditors on the loan. If the funds are
equity, the cost is the return that equity investors expect, both from the stock’s price appreciation
and dividends. Thus, the WACC is a firm’s overall cost of capital (weighted average of the firm’s cost
of equity rE and it’s after tax cost of debt rD), with the weights created by the market values of the
firm’s equity (E) and debt (D); which commonly known as capital structure. To calculate the firm’s
overall cost of capital, we multiply the capital structure weights by the associated costs and add them
up.

Where: E = market value of the firm’s equity; D = market value of the firm’s debt; TC = firm’s corporate
tax rate; rE = firm’s cost of equity; rD = firm’s cost of debt; and, V = value of combined equity and debt
(D+E)

The WACC has two important uses in finance:

When used as the discount rate for a firm’s anticipated free cash flows (FCF), the WACC gives the
enterprise value of the firm (discussed separately in chapter 4).
The WACC is also the appropriate risk-adjusted discount rate for firm projects whose riskiness is
similar to the average riskiness of the firm’s cash flows (the purpose of this chapter).

A terminological note: ―Cost of capital‖ is a synonym for the ―minimum required rate of return‖ in
an investment ―appropriate discount rate‖ to be applied to a series of cash flows. In finance
―appropriate‖ is most often a synonym for ―risk-adjusted.‖ Hence another name for the cost of capital is
the ―risk-adjusted discount rate‖ (RADR) or ―hurdle rate‖.

1. Computing the Value of the Firm’s Equity, E

Of all the computations related to the WACC, computing the value of the firm’s equity is the easiest: As
long as the company is publicly listed, take E to be the product of the number of shares outstanding
times the current value per share. As an example, consider, on 29 June 2012, kraft has 1.670 billion
shares outstanding, each trading at $27.75. The equity value (―market cap‖) of the company is
$46,339,190,951.

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2. Computing the Value of the Firm’s Debt, D
We compute the value of the firm’s debt by the market value of its financial debt minus the market value
of its excess liquid assets. A common approximation for this number is to take the balance sheet value of
the firm’s debt minus the value of the firm’s cash balances and the value of its marketable securities. In
determining cost of capital; short-term liabilities are often ignored in the process. Example:

It is not uncommon for a company to have negative net debt—this occurs when the company has more
cash and marketable securities than debt. When this occurs, we set Debt in the WACC computation to
be a negative number. Holding large/massive reserves of liquid assets (cash and short-term investments)
provide such low financial returns. From a purely financial point of view, corporation would have
benefited its shareholders by using the liquid assets to repurchase its debt or by paying them out as
either dividends or share repurchases. In principle, liquid assets such as cash and cash equivalents are
negative debt and should be subtracted from the firm’s debt. The idea here is that business could use its
cash to pay off part of its debt, so that the effective debt financing of the firm is its financial debt minus
cash. Thus, we prefer to approximate the WACC by using only financial obligations net of liquid assets.

3. Computing the Firm’s Tax Rate, TC

In the WACC formula, TC should measure the firm’s marginal tax rate on additional taxable income, but
it is common to measure it by computing the firm’s reported tax rate (%).

The tax rate for Kraft is reasonably stable at 31% to 29%. In WACC computation we would most likely
use the current tax rate (29.37%) or the average over the past several years.
4. Computing the Firm’s Cost of Debt, rD
The cost of debt is the return that the firm’s creditors demand on new borrowing (cost of debt is
simply the interest rate the firm must pay on new borrowing). In principle, rD is the marginal cost to the
firm (before corporate taxes) of borrowing an additional dollar. However, practically it is the after tax
rate rD = rD*(1 – T C). This is because; interest paid by a corporation is deductible for tax purposes
which means, it has tax advantage/benefit). Payments to stockholders, such as dividends, are not. What
this means, effectively, is that the government pays some of the interest. It is the anticipated future cost
of the firm’s borrowing.

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The cost of debt rD is most commonly computed by using the firm’s current net interest payments
divided by its average net debt. (Net debt: debt minus cash and marketable securities).

Thus,

Were we to use the average cost of debt for Kraft of its future cost of debt rD, we would most likely
use the current cost rD = 5.50% in the WACC computation. This is because we believe that historical
costs of debt have little predictive power for future costs.

Here is a good example to determine after tax cost of debt; suppose a firm borrows $1 million at 9 percent
interest. The corporate tax rate is 34 percent. What is the after-tax interest rate on this loan? The total interest
bill will be $90,000 per year. This amount is tax deductible, however, so the $90,000 interest reduces the
firm’s tax bill by 0.34*$90,000 = $30,600, a tax saving (tax shield). The after-tax interest bill is thus $90,000
- 30,600 = $59,400. The after-tax interest rate is thus $59,400/1 million = 5.94%. Simply, the after-tax
interest rate is 9% * (1 - 0.34) = 5.94%. Notice that, in general, the after-tax interest rate is simply equal to
the pretax rate multiplied by 1 minus the tax rate. [If we use the symbol TC to stand for the corporate tax rate,
then the after-tax rate that we use can be written as rD *(1 – T C).]

5. Computing the Firm’s Cost of Equity, rE

The cost of equity: The return that equity investors require on their investment in the firm common
stock (anticipated dividend). We now come to the most problematic of the computations related to the
WACC parameters—the computation of the cost of equity rE. There are two approaches to rE that
can readily be computed:

Method1: The Gordon dividend model derives the cost of equity from the following deceptively
simple statement:

rE = (D1/P0)+g

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The value of a share (stock) is the present value (discounted value) of the future anticipated dividend
stream from the share, where the future anticipated dividends are discounted at the appropriate risk
adjusted cost of equity rE. The model computes rE based on current dividend D0, current stock price P0,
and the anticipated growth of future dividends g. The simplest application of the Gordon model is the
case where the anticipated future growth rate of dividends is constant. To apply this formula, consider a
firm whose current dividend is D0=$3 per share, whose share price is Po= $60. Suppose the dividend is
anticipated to grow by 12% per year into the indefinite future. Then the firms’ of equity rE is 17.6%:

Non-constant Growth The last case we consider is non-constant growth. We discussed earlier, the
growth rate cannot exceed the required return indefinitely, but it certainly could do so for some number
of years. To avoid the problem of having to forecast and discount an infinite number of dividends, we
will require that the dividends start growing at a constant rate sometime in the future.

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Method2: The Capital Asset Pricing model (CAPM)
CAPM is the only viable alternative to the Gordon model for calculating the cost of capital. It is also the
most widely used cost of equity model. Rather than estimating the future dividend stream of the firm
using the sophisticated methods and then solving for the cost of equity capital, we may approach the
problem directly by estimating the required rate of return on the company’s common stock (cost of
equity capital) relatively by simple, ―quick and dirty,‖ approach. Here the company’s before/after -tax
cost of debt forms the basis for estimating the firm’s cost of equity. The common stock of a company
must provide a higher expected return (i.e., cost of common stock) than the debt (i.e., risk free rate) of
the same company (firm’s own long-term debt) because of risk premium.
In the capital asset pricing model, the security market line (SML) is used to calculate the risk-adjusted cost
of equity capital. In this section we consider two SML formulations. The difference between these two
methods has to do with the way taxes are incorporated into the cost of equity capital equation.

I) The classic CAPM (The Classic Security Market Line (SML)

What the CAPM shows is that the expected return for a particular common stock depends on three
things:
1. The pure time value of money. As measured by the risk-free rate of interest, rf, this is the reward for
merely waiting for your money, without taking any risk.
2. The reward for bearing systematic risk. As measured by the market risk premium, E(rM)-rf, this
component is the reward the market offers for bearing an average amount of systematic risk in addition
to waiting. It is a reward for uncertainty of the future payments. It is market risk premium they bear by
owning the stock.
3. The amount of systematic risk. As measured by- β, this is the amount of systematic risk present in a
particular stock, relative to that in an average stock. Thus: rE based on the risk-free rate rf, the expected
return on the market E(rM), and a firm-specific risk measure beta β.

II) The Tax-Adjusted CAPM (The Tax-Adjusted Security Market Line (SML)
The classic CAPM approach makes no allowance for taxation. Benninga-Sarig (1997), show that the
SML has to be adjusted for the marginal corporate tax rate in the economy. Denoting the corporate tax
rate by TC, the formula can be applied by substituting rf(1 − TC) for rf in the classic CAPM.
Another way to write the tax-adjusted cost of equity is:

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Kraft’s rE Using the CAPM
Kraft has a beta (β) equal to 0.47. Using a market price-earnings multiple to compute E(rM) as illustrated
below, we compute rE = 6.82 percent using the classic CAPM and 6.05 percent using the tax-adjusted
CAPM:

The basic idea behind the capital asset pricing model is that investors expect a reward for both waiting and
worrying. If you invest in a risk-free Treasury bill (debt), you just receive the rate of interest. That’s the
reward for waiting. When you invest in risky stocks, you can expect an extra return or risk premium for
worrying.
Thus, the cost of common stock is the sum of the investor’s compensation for the time value of money and the
investor’s compensation for the market risk of the stock (risk premium).
In short, cost of equity (rE) under CAPM is about; before- tax (classic CAPM) or after-tax (Tax-Adjusted CAPM)
cost of debt plus risk premium.

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 Computing the WACC for Kraft Corporation

So what is Kraft’s WACC? Is it in the range of 5–6 percent (the two Gordon-based models) or in the
range of 12–14 percent (the two CAPM-based methods)? One way to get a feel for the answer to this
question is to look at other companies in the same sector. All of the estimates for other company’s
WACC are in the lower range of Kraft’s estimates. If this is indicative (and we think it is), then we
conclude that Kraft’s WACC is somewhere between 5.64 and 6.26 percent;—on AVERAGE 5.95
percent. Further as it is seen in the above table; the Gordon-based models produce significantly lower
estimates for the rE and WACC than the CAPM-based methods. In this case we take the average of the
two latter computations (our general preference is often for CAPM over the dividend models).

Three Approaches to Computing the Expected Return on the Market, E(rM)

• The historical return on a major market index
• The historical market risk premium on the market index
• The Gordon model

Problems with the Gordon Model

Obviously the Gordon model doesn’t work if a firm doesn’t pay dividends and appears to have no
intention—in the immediate future—of paying dividends. But even for dividend-paying firms, it may be
difficult to apply the model. Particularly problematic, in many cases, is the extraction of the future
dividend payout rate from past dividends. Further, the key underlying assumption is that the dividend
grows at a constant rate, which is in fact rare. Finally, this approach really does not explicitly consider
risk.