One of the most important aspects of financial theory in financial modeling and valuation is the weighted average cost of capital (WACC). The WACC is the discount rate, or time value of money, used to convert expected future cash flow into present value.
In practical terms, WACC represents what it would cost, on average, to raise another dollar for the company.
Calculating the Cost of Equity
The cost of equity can be defined as the minimum rate of return that a company must earn on the equity-financed portion of its investments in order to leave unchanged the market price of its stock.
Most companies use the Capital Asset Pricing Method (‘CAPM’) to calculate their cost of equity capital. In the CAPM definition, the cost of equity is equal to the return on risk-free securities plus the company’s systematic risk (beta) multiplied by the market risk premium.
- Rf : The common choice for the risk free rate for valuation of long term investments is the yield on long term US treasury bonds.
- Beta: The Beta of a stock indicates the degree to which the stock’s return moves with that of the overall market.
- If Beta = 1.0, the stock is as risky as the overall market and therefore will provide expected returns equal to those of the market. Stocks with Beta of 1.5 will, on an average rise 150% of overall market during rising prices and fall 150% of overall market during falling prices.
- Beta incorporates only the systematic risk that affects every stock. Unsystematic risk can be avoided by diversifying one’s portfolio and is ignored in estimating the beta. Under CAPM, taking systematic risk is awarded with a risk premium.
- In case of publicly traded companies, published estimates of historical beta are available. For unlisted companies, Betas of listed companies with similar risk profile are used as proxy after adjusting for the degree of leverage (refer to handouts for formulae).
- Rm : The long term expected return on market index is estimated using historical data on the average returns on the stock market. A common practice is to use a long data series to reduce volatility. The recommended Rm- Rf is a range of 6% to 8% based on realised equity risk premia from 1926 till date.
Calculating the Cost of Debt
The cost of debt can be defined by the minimum after tax rate of return that a company must earn on the debt-financed portion of its investments in order to leave unchanged the market price of its stock.
We now have all the components to calculate WACC for a financial modeling or financial analysis exercise.
Look at the illustration below for an example of how to do this :
Visit Finance 3.0 - don't miss out on this high quality financial learning opportunity