Investment Banking

WEIGHTED AVERAGE COST OF CAPITAL In its simplest form, the weighted average cost of capital is
the market-based weighted average of the after-tax cost of debt and cost of equity: where D/V =
Target level of debt to enterprise value using market-based (not book) values E/V = Target level of
equity to enterprise value using market-based values kd = Cost of debt ke = Cost of equity Tm =
Company’s marginal income tax rate For companies with other securities, such as preferred stock,
additional terms must be added to the cost of capital, representing each security’s expected rate of
return and percentage of total enterprise value. The cost of capital does not include expected returns
of operating liabilities, such as accounts payable. Required compensation for funds from
customers, suppliers, and employees is included in operating expenses, such as cost of goods sold,
so it is already incorporated in free cash flow. Including operating liabilities in the WACC would
incorrectly double-count their cost of financing.

To determine the cost of equity, we rely on the capital asset pricing model (CAPM), one of many
theoretical models that convert a stock’s risk into expected return.1 The CAPM uses three variables
to determine a stock’s expected return: the risk-free rate, the market risk premium (i.e., the expected
return of the market over risk-free bonds), and the stock’s beta. In the CAPM, beta measures a
stock’s co-movement with the market and represents the stock’s ability to further diversity the
market portfolio. Stocks with high betas must have excess returns that exceed the market risk
premium; the converse is true for low-beta stocks. To approximate the cost of debt for an
investment-grade firm, use the company’s yield to maturity on its long-term debt. For companies
with publicly traded debt, calculate yield to maturity directly from the bond’s price and promised
cash flows. For companies with illiquid debt, use the company’s debt rating to estimate the yield to
maturity. Since free cash flow is measured without interest tax shields, measure the cost of debt on
an aftertax basis. Finally, the after-tax cost of debt and cost of equity should be weighted using
target levels of debt to value and equity to value. For mature companies, the target capital structure
is often approximated by the company’s current debt-to-value ratio, using market values of debt and
equity. As will be explained later, you should not use book values. In Exhibit 10.1, we present the
WACC calculation for Home Depot. The company’s cost of equity was determined using the CAPM,
which led to a required equity return of 9.9 percent. To apply the CAPM, we used the December
2003 10-year U.S. government bond rate of 4.3 percent, a market risk premium of 4.5 percent, and a
relevered industry beta of 1.23. As a proxy for Home Depot’s pretax cost of debt, we used the yield
to maturity on AA-rated debt (4.7 percent). In Chapter 7, we estimated Home Depot’s marginal tax
rate at 38.2 percent, so its after-tax cost of debt equals 2.9 percent. Finally, we assume Home Depot
will maintain a current debt-to-value ratio of 8.3 percent going forward.2 Adding the weighted
contributions from debt and equity, we arrive at a WACC equal to 9.3 percent. We discuss each
component of the weighted average cost of capital next. ESTIMATING THE COST OF EQUITY To
estimate the cost of equity, we must determine the expected rate of return of the company’s stock.
Since expected rates of return are unobservable, we rely on asset-pricing models that translate risk
into expected return. The most common asset-pricing model is the capital asset pricing model
(CAPM). Other models include the Fama-French three-factor model and the arbitrage pricing theory
(APT). The three models differ primarily in how they define risk. The CAPM defines a stock’s risk as its
sensitivity to the stock market,3 whereas the Fama-French three-factor model defines risk as a
stock’s sensitivity to three portfolios: the stock market, a portfolio based on firm size, and a portfolio
based on book-to-market ratios. The CAPM is the most common method for estimating expected
returns, so we begin our analysis with that model. Capital Asset Pricing Model Because the CAPM is
discussed at length in modern finance textbooks,4 we will not delve into the theory here. Instead, we
focus on best practices for implementation. The CAPM postulates that the expected rate of return on
any security equals the risk-free rate plus the security’s beta times the market risk premium: E(Ri ) =
rf + βi [E(Rm) − rf ]

where E(Ri ) = Security i’s expected return rf = Risk-free rate βi = Stock’s sensitivity to the market
E(Rm) = Expected return of the market In the CAPM, the risk-free rate and market risk premium
(defined as the difference between E(Rm) and rf ) are common to all companies; only beta varies
across companies. Beta represents a stock’s incremental risk to a diversified investor, where risk is
defined by how much the stock covaries with the aggregate stock market. Consider General Mills, a
cereal manufacturer, and Cisco, a maker of network routers. Consumer cereal purchases are
relatively independent of the stock market’s value, so the beta for General Mills is low; we estimated
it at 0.4. Based on a risk-free rate of 4.3 percent and a market risk premium of 5 percent, the cost of
equity for General Mills is estimated at 6.3 percent (see Exhibit 10.2). In contrast, technology
companies tend to have high betas. When the economy struggles, the stock market drops, and
companies stop purchasing new technology. Thus, Cisco’s value is highly correlated with the market’s
value, and its beta is high. Based on a beta of 1.4, Cisco’s expected rate of return is 11.3 percent.
Since General Mills offers greater protection against market downturns than Cisco, investors are
willing to pay a premium for the stock, driving down expected returns. Conversely, since Cisco offers
little diversification to the market portfolio, the company must earn higher returns to entice
investors. Although the CAPM is based on solid theory (the 1990 Nobel Prize in Economics was
awarded to the model’s primary author, William Sharpe),