Part – 9

In our last tutorial, we have understood basics for calculation of  Weighted Average Cost of Capital (WACC). In this article we will learn about the Weighted Average Cost of Capital (WACC)

Use the Weighted Average Cost of Capital (WACC) to determine the appropriate discount rate range. Principally, nominal free cash flows should be discounted by a nominal rate and the real flows by the real rate.

What is Weighted Average Cost Of Capital or WACC ?

One of the best and most commonly used measures of the riskiness of projected cash flows (and the best way to determine the correct range of discount rates) is the Weighted Average Cost of Capital (WACC). This WACC is the weighted average of the after-tax cost of a company’s debt and the cost of its equity. WACC analysis assumes that capital market investors (both debt and equity) in any given industry require returns commensurate with the perceived riskiness of their investment.

WACC Definition of Formula

A simple overview of a company’s WACC calculation can be illustrated by:

WACC formula

  • There is no charge on the income statement which reflects the cost of equity (as there is interest expense associated with debt). The concept of taxation does not apply to equity
  • Not net debt, rather the market value of debt

The cost and proper weighting of each type of financing must be included in a WACC calculation. For example, if a portion of the company’s capital structure is preferred equity, its cost and proper weighting must be factored into the WACC along with the company’s cost of debt and equity.

Note that the cost of preferred equity is usually its dividend yield.

Typically, a company’s optimal capital structure includes a proportion of debt; debt is typically cheaper than equity, and the interest payments on debt are tax deductible, resulting in a ‘tax shield’. Note that you should use a target level of debt to represent its optimal capital structure. The structure implied from a company’s balance sheet may be different from its long-term optimal capital structure. As such, the calculation may need to be adjusted over time if the capital structure changes.

Step 10 – WACC – Calculate Cost of Debt

You can’t just go to a company’s annual report and capture their cost of debt for use in your WACC calculation. The cost of debt in the annual report is historical and may not reflect your choice of debt – equity mix in your WACC or the cost of debt in the future. You must find the company’s future cost of debt for the credit rating implied by the debt-equity mix in your WACC.

Method 1: Yield to Maturity Approach (Only for Public Debt) 

Determine the Weighted average of current yields to maturity on all issues in the target capital structure. The yield to maturity incorporates the market’s expectations of future returns on debt and should be used instead of the coupon rate

Method 2: Credit Rating Approach

First determine the credit rating the company would have been given your assumed debt-equity mix. S&P, Moody’s and other credit rating services publish ratio guidelines for different credit ratings. The rating guideline change frequently, so check for the latest information. Once you have the credit rating, check Bloomberg for yield to maturity on publicly traded long term bonds with the same credit rating.

Cost of debt Formula

The difference between company’s cost of debt and the benchmark rate (LIBOR/Government Bond) is called a Spread

Method 3: Synthetic Rating Method

If the company bonds are not listed, then one must calculate the implied synthetic default spread.

Synthetic Rating Method

Calculation of Synthetic Default Spread

  • Calculate the interest coverage ratio = EBIT / Interest Expense.
  • Derive the Synthetic default spread as per the table below.

Calculation of Synthetic Default Spread

Note – This is just a guideline table. However, you should check with your senior for the revised updated table.

Method 4: Company Report Method (Spot Check!)

From the Annual report / quarterly report find interest rate applicable on each debt. The cost of debt may be historical but it may provide a good double check.

Company Report Method (Spot Check!)

Cost of Debt Calculation for Company ABC

Using synthetic rating method, we have Interest coverage ratio = EBIT / Interest Expense

Interest Expense for ABC company (small cap $257million) is 15; Interest coverage ratio = 50/15 = 3.33

Cost of Debt Calculation

Pre tax Cost of Debt = Risk Free rate + default spread = 5.0% + 3.50% = 8.50%

Post tax cost of debt = 8.50% x (1-33%) = 5.70%

Note – we have assumed Risk Free Rate to be 5.0%.(please see the detailed note below on risk free rate)

What Next

In this article we have understood the WACC; we will look at the cost of equity.Till then, Happy Learning!