New on FinoLib · Volume II: Capital Markets
I have added a new article to FinoLib, my finance education website: WACC Formula and CAPM: How to Calculate Cost of Capital, part of Volume II: Capital Markets. This page gives you the core of the topic in expert but plain language; the full article goes much deeper.
1.4 The Weighted Average Cost of Capital (WACC)
The idea in plain words
A company funds itself with a mix of borrowed money and owners’ money, and each has a price. WACC, the weighted average cost of capital, blends the two prices using how much of each the company uses. Borrowing is cheaper, partly because the interest saves tax, but owners demand a higher return for taking more risk. The borrowing cost should be what the company would pay today, never an old coupon. For Harbor Tools the blend comes to about 8.5%.
Key points
■Harbor’s bonds yield 6.2%; a synthetic rating from 3.89x interest coverage gives A− and 6.09%.
■In the three-scenario comparison, WACC bottoms at 8.34% with 42% debt, then jumps as coverage falls below 2.5x and the IRC §163(j) cap bites.
■Using a 3% coupon from 2021 instead of today’s 6.2% yield overvalues Harbor by 20%.
A closer look
A company is financed by a mix of debt and equity, and each source of capital demands its own return. Lenders want interest; shareholders want a return commensurate with the risk they are taking on. WACC blends these two costs, weighted by how much of each the company actually uses, into a single discount rate representing the minimum return the company’s overall capital must earn to satisfy everyone who funded it.
Decision rule
Weight debt and equity by target market values, not book values. Take Rd from the yield to maturity on the company’s long-term debt if it is investment grade and trades; otherwise use a synthetic rating (coverage, then spread, then risk-free rate plus spread). Tax-effect Rd at the marginal rate, and cut that rate where losses or the IRC §163(j) cap limit the deduction. Recompute WACC when the target mix moves by more than about 10 points of D/V (a working heuristic).
The costliest mistake
Using the coupon on old debt as the cost of debt. Suppose Harbor’s bonds had been issued in 2021 with a 3% coupon. Plugging 3% into the formula instead of today’s 6.2% yield gives WACC = 0.07089 + 0.30 × 0.03 × 0.75 = 7.76%, and the same DCF then values Harbor at $18.34 a share instead of $15.24: a 20% overvaluation from a number copied off the balance sheet. Avoid it by pricing debt from current yields or a synthetic rating, never from the interest-expense line.
Recap
WACC weights the after-tax cost of debt and the cost of equity by target market values, giving Harbor 8.48%. The cost of debt comes from a current yield or a synthetic rating, and debt lowers WACC only until coverage, ratings and the interest-deduction cap turn against it.
1.5 CAPM — The Cost of Equity
The idea in plain words
The cost of equity is the return shareholders expect for owning a company’s stock. CAPM builds it in three steps. Start with the return on a safe investment, then add extra for the risk of the stock market as a whole, then scale that extra by beta, which measures how strongly this company’s stock swings compared with the market. A beta above one means bigger swings than the market. For Harbor Tools the answer is 10.13%.
Key points
■Beta measures only market-linked risk: a volatile stock that moves independently of the market can have a low beta.
■Take beta from peers: unlever at their leverage (1.08 → 0.91), then relever at the target’s (→ 1.20).
■Skipping the relevering step overvalued Harbor by 9.4%.
Decision rule
Use the yield on a Treasury whose maturity is close to the duration of the cash flows (the 10-year for most company DCFs), and pair it with an equity risk premium estimated on the same date against a comparable rate. Take beta from a peer median, unlevered at each peer’s own D/E and tax rate and relevered at the target’s, rather than from one regression on the company’s own shares. If peer betas span more than about 0.5, narrow the set to closer business matches before averaging (a working heuristic).
The costliest mistake
Plugging in a peer’s levered beta without relevering. Harbor’s peers carry D/E of 0.25; Harbor targets 0.43. Use the peers’ 1.08 directly and Re = 0.052 + 1.08 × 0.041 = 9.63%, WACC = 0.70 × 0.0963 + 0.01395 = 8.13%, and the DCF gives $16.67 a share instead of $15.24: a 9.4% overvaluation from forgetting that Harbor’s shareholders carry more financial risk than the peers’ shareholders. Avoid it by always unlevering peers at their own leverage and relevering at the target’s.
What the full article covers
In the full article I take you through these sections:
■1.4 The Weighted Average Cost of Capital (WACC)
■1.5 CAPM — The Cost of Equity
It includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume II: Capital Markets
Read the full article on FinoLib
The complete article, WACC Formula and CAPM: How to Calculate Cost of Capital, with every worked example, diagram, quiz and source, is free to read in Volume II, Capital Markets on finolib.com.
Explore the Finance Education Series: Vol. II — Capital Markets · Vol. I — Global Economy · Vol. III — Finance Encyclopedia · Vol. IV — Finance Careers · Vol. V — Personal Finance