4. The Cost of Capital Part 1

Overview

Central to income-based valuation is the cost of capital, which represents the required rate of return for an investor. In this lesson, I show you how to calculate the weighted average cost of capital for MarkerCo.

Summary

  1. Lesson Goal (00:00)

    The goal of this lesson is to learn how to calculate the Weighted Average Cost of Capital, or WACC.

  2. Understanding Discount Rates (00:04)

    We can value a company by forecasting future cashflows, applying a discount rate to these cashflows, and adding the value of these discounted cashflows. The biggest issue in this process is identifying the appropriate discount rate to use. The choice of discount rate can have a significant impact on the company’s valuation. Additionally, debt and equity will have different discount rates. The appropriate discount rate is equivalent to the rate of return required by investors in the company.

  3. Formula for WACC (01:09)

    The Weighted Average Cost of Capital, or WACC, is a method for calculating the required rate of return, or the cost of capital, for people investing in a business. Debt holders and equity holders have different costs of capital, so the WACC provides a weighted average of these two figures. The formula for WACC is as follows:

    \(WACC = r_D(1-T_C)\frac{D}{V}+r_E\frac{E}{V}\)

    In the formula above:

    • \(r_D\) is the required rate of return for debt holders, or the cost of debt
    • \(r_E\) is the required rate of return for equity holders, or the cost of equity
    • \(T_C\) is the corporate tax rate
    • \(D\) is the market value of debt in the company
    • \(E\) is the market value of equity in the company
    • \(V\) is the market value of debt and equity in the company, i.e. \(V = E + D\)

    The first part of the formula deals with the required rate of return for debt holders. Interest payments on debt reduce the amount of tax the company pays. As a result, the effective cost of debt is reduced by an amount that depends on the corporate tax rate. The fraction expression represents the weighting, and its size represents the proportion of debt and equity in the company that is held as debt.

    The second part of the formula deals with the required rate of return for equity holders. The cost of equity is weighted by the proportion of debt and equity in the company that is held as equity. Adding the two components of the formula produces the WACC, or the discount rate that can be used to value the company based on its future cashflows.

  4. Issues with Calculating WACC (03:41)

    The most difficult part of calculating WACC is identifying the figures to use for the cost of debt and especially the cost of equity. The cost of debt can be found by identifying the interest rate of the company's bonds, if it has them, or the cost of the last debt raised by the company otherwise. Calculating the cost of equity is harder. Shares do not have an explicit cost, like an interest rate, but equity holders do expect some level of return. As a result, more advanced methods are needed to calculate the cost of equity.

Transcript

In previous courses, you may have heard me explain a concept called the time value of money and discounting future cashflows. Essentially, to calculate the value of an asset, we forecast future cashflows, and then discount these cashflows by the discount rate before adding the discounted cashlfows together to calculate our net present value.

The same principle applies when valuing companies. We calculate the future cashlfows for the company, and then discount these cashlfows back to a present value. But what should this discount rate be? This is one of the most contentious questions in finance and it's important because the discount rate you use can dramatically change your valuation of a company. For businesses we have the added complication of debt and equity. Which will have different discount rates. Analysts often disagree how the discount rate is calculated and it's important, when valuing a business, to stand over your discount rate assumptions. While analysts disagree often on what the correct discount rate for a company is, at least they do use the same concept called the Weighted Average Cost of Capital. Form an investors perspective, the cost of capital is the required rate of return by those investing in the business. Needless to say, the required rate of return for a debt holder is different to that of an equity holder. And the weighted average cost of capital simply calculates the weighted average for both the debt and equity investors in the company. So let's take a look at the formula for calculating the weighted average cost of capital. There's quite a few variables, so what I'll also include is my definition for each of these variables. So the weighted average cost of capital is equal to the cost of debt, multiplied by one minus the tax rate. This is then multiplied by a fraction, which is the market value of the debt, divided by the market value of the debt, plus the market value of the equity. And so, this portion of the equation looks after the cost of debt. And then, the second portion of the equation, looks after the cost of equity, which is r e, and multiply it by the market value of the equity, divided by the market value of the debt, plus the equity. Let's now apply some values to this formula so you can see it in action for a fictional company. And for this fictional company, I'm going to assume that there's a cost of debt, or an interest rate payment, of 5%.

I'm also going assume that the corporation tax rate is based on the U.S. and 35%.

Because interest payments on debt reduce the amount of tax the company pays, the effective cost of debt is lower than 5%. And this is why we apply the one minus Tc value to the WACC formula.

The next part of our equation is debt divided by the market value of debt plus equity. I'm going to assume a debt equity ratio of 1:1. So half of my WACC will be based off the cost of debt and the other half will be based off the cost of equity. And I'm going to assume here that the cost of equity is 8%.

Using some simple multiplication, I'll run the calculation, and find that my WACC is 5.625%.

While this seems relatively straightforward, the most contentious aspect of this formula is the cost of equity. The cost of debt can be relatively easy to find for large companies who have bonds that are currently traded in reasonably liquid markets. However, for smaller businesses, the cost of debt can be more difficult to estimate. In many cases, the analysts will often use the cost of the last debt that was raised by the business as the current cost of debt. The cost of equity is even trickier because shares do not carry an explicit cost, like an interest rate. While equity does not have a specific, concrete price, like debt, it does not mean that the cost of equity is zero.

As a result, we need to apply more advanced analysis to calculate the cost of equity. Perhaps the most popular way of doing this is the capital asset pricing model. Which I'll show you in the next lesson.