Weighted average cost of

capital

Timothy A. Thompson
Executive Masters Program
What is the WACC?
WACC = (D/D+E) rd (1-Tc) + (E/D+E) reL

• D/D+E and E/D+E are capital structure weights evaluated at

market value, based on the firm’s target capital structure
• Tc is the firm’s marginal tax bracket, but the effective tax
rate is often used as estimate
• rd is the cost of debt based on the risk of the debt (which
depends on the debt ratio)
• reL is the required rate of return on equity (I.e. the cost of
equity)
– the cost of equity depends on the business risk of the
assets
– and on the debt ratio
Why the WACC?
Measures the returns demanded by all
providers of capital
Investments must offer this return to be
worth using the capital providers’ money
As an opportunity cost
The rate of return investors could earn
elsewhere on projects with the same risk
and capital structure
WACC incorporates debt tax shields
The (1-T) term incorporates the fact that debt
returns are tax deductible
Discounting project cash flows at WACC is an
alternative to adding in the value of tax
shields (ala AHP)
Key assumption: constant D/D+E ratio is
reasonable as a target capital structure
Risk and return
It is reasonable to believe that the
higher the risk of an investment, the
higher its required return. But …
What is risk, and …
What is the relation between risk and
required return?
Capital Asset Pricing Model
The result will be that risk of investment
(stock j) is measured by its beta ( j)
Any risky security has a required return given
by:
the risk free rate of return, rf, plus
a risk premium which is proportional to its beta
risk
Equation: rj = rf + j (avg. risk prem.)
Diversification: roulette wheel
Fair roulette wheel
• 40 slots, 20 black, 20 red (no house slots)
• probability of red = 50%
Bet $10,000 on red, one spin
risky?
50% prob of 100% loss
Bet $1 per spin on 10,000 spins: as risky?
Why is it less risky?
Diversification reduces risk
Investors don’t hold only one stock
Smart investors hold diversified portfolios
Why doesn’t risk go to zero as in the roulette
wheel?
• Because stocks are correlated with each other, with the
market as a whole
• This is risk you can not diversify away
• For risk you must bear, you demand a premium!
What measures non-diversifiable
risk?
Beta
• Covariance measures the degree to which two
things “move together” on average
• The more a stock moves up and down with the
market, the more non-diversifiable risk it has
• How much “risk” is in the market portfolio
itself?
• The variance of the market
• Beta = Covariance of stock with
market/Variance of the market
What is the beta of the market?
Beta of market portfolio is one
• Covariance of market with itself/Variance of
market
• Covariance of anything with itself is its own
variance
The market risk premium
• rm - rf is the risk premium on the market, so it
is the risk premium for a beta of one
Back to the equation
CAPM
rj = rf + j (rm - rf)

assets with betas less than one demand

lower returns than rm
assets with betas greater than one demand
higher returns than rm
How do you apply CAPM?
Common assumption: discounting
future, long term cash flows
so, you want a long term discount rate (forward
looking if possible)
rf is long term government bond rate (forward
looking, I.e., current long term T bond rate)
rm - rf is expected excess return on a very
diversified portfolio of stocks (S&P500?) over long
term government bonds (forward looking not
available, so often use historical average)
How do you estimate beta?
Many services calculate beta estimates
for stocks (some bonds)
Value Line, investment banks
The beta is a statistical estimate
• Slope coefficient of a linear regression of the
stock’s returns against the proxy for the market
portfolio’s returns
A stock’s beta is a levered beta
• Based on the debt ratio it has now
Estimating Charles Schwab beta

Schwab's returns vs. Market returns

0.4
0.2
Schwab
Returns

0
-0.10 -0.05 -0.20.00 0.05 0.10
-0.4
Returns on Market
Regression for Charles Schwab
SUMMARY OUTPUT Charles Schwab

Regression Statistics

Multiple R 0.494088888

R Square 0.24412383

Adjusted R Square 0.231091482

Standard Error 0.100953718

Observations 60

ANOVA

  df SS MS F Significance F

Regression 1 0.190911525 0.190912 18.73215 6.02E-05

Residual 58 0.591115881 0.010192

Total 59 0.782027406      

  Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Intercept 0.006291272 0.014464831 0.434936 0.665223 -0.02266 0.035246

Slope on market 2.30 0.53 4.33 0.00 1.23 3.36

Corporate WACC vs. Project WACC
The corporate WACC is not necessarily the
cost of capital for a project within the firm:
The systematic risk of the project could differ from
the average systematic risk of the firm’s projects
The target capital structure for the project
(thought of as a mini-firm) could differ from the
corporate target capital structure
 Project-beta
Adjusted
Expected Cost of capital
Rates
Of
Return
Y
Company-wide
WACC
X

Avg. company
Project beta Project Beta
How do you estimate the beta of
a project or division?
Peer method
Collect a sample of publicly traded firms which are
essentially like (you think they face the same
systematic risk) the project or division being
valued
Estimate (or look them up) the peer companies’
equity betas
Assuming they face the same business risk, not
the same financial risk (I.e., different capital
structures)
Equity risk
Equity beta risk has two sources:
Business risk (the risk of the asset cash
flows)
• which would equal the equity risk if the business
were unlevered (I.e., if it had no debt)
Financial risk
• The magnification of the business risk from the
perspective of the equityholders because of the
presence of debt in the capital structure.
Unlever the peer betas
Peers have same business risk as
project
so back out the financial risk … How?
First, estimate reL for peers using CAPM
Then use the unlevering formula:
reU = [reL + (1-T)(D/E)(rd)]/[1 + (1-T)(D/E)]
For this formula, you technically need the peers’
costs of debt and marginal tax rates (for our
assignment, assume the same as Marriott’s)
Average the reU’s
These are now estimates of required returns
for business risk only!
Average the reU’s
This is your project’s reU
The WACC needs reL
You are using WACC to value the
project or division
How do you get reL for the WACC?
Relevering formula:
reL = reU + (1-T)(D/E)(reU - rd)
Plug in your WACC
Your reL is now ready for your WACC
Estimate Tc, the capital structure
weights and rd and you’re ready to go!
Look at the lodging WACC
Assignment: Bring back a restaurant
division WACC!
Extra credit
For extra credit, bring back a contract
services division WACC
There are no peers given for contract
services
But you can estimate WACC, reu, reL, etc.
for Marriott as a whole!