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Corporate Finance
Constituents of the WACC

Objectives

• How can we compute different constituents of the WACC?

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Constituents of the WACC

Constituents of the WACC

Constituents of the WACC

• Three of the most important inputs for the calculation of the WACC
are the following:
• Cost of Debt
• Cost of Preferred Stock
• Cost of Equity

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Constituents of the WACC

Floatation Costs

• In order to correctly identify the financing costs associated with

new funds (raised through issuing new securities), we need to
adjust the financing costs for floatation costs.
• We should deduct the floatation costs from the proceeds that a
firm generates from selling new securities.

Constituents of the WACC

Floatation Costs

• Floatation costs represent the total costs of issuing and selling

securities. They include two components:
• Underwriting Costs: These costs are the compensation earned by
investment bankers for selling the security.
• Administrative Costs: These are the costs that issuer bears (such as legal,
accounting, and printing).

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Constituents of the WACC

Floatation Costs: Example 1

• OF Corporation is contemplating selling a 20-year, 9% coupon

bond with a face value (par value) of $1000. Because current
market interest rates are equal to 9%, the firm must sell the bonds
at $1000.
• What are the net proceeds to the firm from each bond? Assume
that flotation costs are 2% of face value or $20.

Constituents of the WACC

Floatation Costs: Example 1

• The net proceeds to the firm from each bond will be $980 [=$1000
– $20].

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Constituents of the WACC

Cost of Debt

Cost of Debt

• The cost of debt is the financing cost associated with new funds
raised through long-term borrowing. It measures the return that a
firm promises to its debt holders.

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Cost of Debt

• A firm’s before-tax cost of debt (ReturnDebt) can be computed by

the following methods:
• Quotation
• Calculation
• Approximation

Cost of Debt
Quotation Method

• Quotation is a relatively quick method for finding the before-tax

cost of debt. In this method, we observe the yield to maturity
(YTM) on firm’s existing bonds or bonds of similar risk issued by
other companies.
• We can obtain the bond yields from public sources, such as ‘The
Wall Street Journal’.

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Cost of Debt
Calculation Method

• In calculation method, we find the before-tax cost of debt by

calculating the YTM generated by bond’s cash flows.

Cost of Debt
Calculation Method: Example 1

• Assume that ADA Corporation’s bond has the following

characteristics:
• Bond Price = $1000
• Underwriting Costs = $40
• Coupon Payments for 20 Years = 0.09 * $1000 = $90
• Face Value = $1000
• What is the before-tax cost of debt?

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Cost of Debt
Calculation Method: Example 1

• The before-tax cost of debt can be computed by solving the

following equation:
1 1  $1000
$960  $90 *   20 

 r r * 1  r   1  r 
20

 r  9.452%

Cost of Debt
Approximation Method

• Approximation method approximates the before-tax cost of debt

for a bond with a $1000 par value by using the following equation:
$1000  N d
I
rd  n
N d  $1000
2
• In the above equation, I is the annual interest payment, Nd is the
net proceeds from the sale of debt, and n is the number of year’s to
maturity.

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Cost of Debt
Approximation Method: Example 1

• Compute before-tax cost of debt for the bond with following

characteristics:
• I = $90
• Nd = $960
• n = 20 years

Cost of Debt
Approximation Method: Example 1

• Before-tax cost of debt can be computed as follows:

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Cost of Debt
After-tax Cost of Debt

• The after-tax cost of debt can be found by multiplying the before-

tax cost by (1 – Tax Rate).
• After-tax Cost of Debt = Before-tax Cost of Debt * (1 – Tax Rate)
• The relevant cost of debt is the after-tax cost of debt.

Cost of Debt
After-tax Cost of Debt: Example 1

• OF Corporation has two issues of debt outstanding. One is 9%

coupon bond with a face value of $20 million, a maturity of 10
years, and a YTM of 10%. The coupons are paid annually.
• The other bond issue has a maturity of 15 years, with coupons also
paid annually, and a coupon rate of 10%. The face value of the
issue is $25 million, and the issue sells for 94% of its face value.
• The firm’s tax rate is 35%. What is the before-tax cost of debt for
OF Corporation? What is the after-tax cost of debt?

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Cost of Debt
After-tax Cost of Debt: Example 1

• First Bond: The 9% coupon bond has a yield to maturity of 10%

and sells for the following price:
 1 1  $20
PV  $1.8 *   10 

 0.10 0.10 * (1  0.10)  1  0.10
10

 $18.77 million

• NOTE: Coupon payment is $1.8M [= 0.09 * $20M]

• Thus, the market value of first issue is $18.77 million.

Cost of Debt
After-tax Cost of Debt: Example 1

• Second Bond: The 10% coupon bond sells for 94% of face value.
Therefore, the YTM is computed as follows:
1 1  $25
$23.5  $2.5 *   15 

 r r * (1  r)  1  r 
15

 r  10.83%

• NOTE: Coupon payment is $2.5M [=0.10 * $25M] and bond price is

$23.5M [=0.94 * $25M]
• Thus, the market value of second issue is $23.50 million.

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Cost of Debt
After-tax Cost of Debt: Example 1

• The weighted-average before-tax cost of debt is given as follows:

 $18.77   $23.50 
 $18.77  $23.50 *10%   $18.77  $23.50 *10.83%
   
 10.46%

Cost of Debt
After-tax Cost of Debt: Example 1

• The weighted-average after-tax cost of debt (WACD) is given as

follows:
• WACD = (1 – 0.35) * 10.46% = 6.80%

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Constituents of the WACC

Cost of Preferred Stock

Cost of Preferred Stock

• Preferred stock gives its holders the right to receive their stated
dividends before common stockholders.

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Cost of Preferred Stock

• Most preferred stock dividends are stated as a dollar amount: “x

dollars per year”. When dividends are stated this way, the stock is
often referred to as “x-dollar preferred stock”.
• Thus a “$4 preferred stock” is expected to pay preferred
stockholders $4 in dividends each year on each share of preferred
stock owned.

Cost of Preferred Stock

• Sometimes preferred stock dividends are stated as an annual

percentage rate. This rate represents the percentage of the stock’s
face value that equals the annual dividend.
• For instance, an 8% preferred stock with a $50 par value would be
expected to pay an annual dividend of $4 per share [=0.08 * $50].

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Cost of Preferred Stock

• The cost of preferred stock is the ratio of the preferred stock

dividend to the firm’s net proceeds from the sale of the preferred
stock.
• The net proceeds represent the amount of money to be received
minus any flotation costs.

Cost of Preferred Stock

• Therefore, if preferred stock pays a dividend of Dp and net

proceeds available from the sale of preferred stock are Np, the cost
of preferred stock will be:
Dp
r
Np

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Cost of Preferred Stock

Example 1

• ADA Corporation is contemplating the issuance of a preferred

stock that pays $8.70 as dividend. The stock is expected to sell for
$87. The cost of issuing and selling the stock is expected to be $5
per share. What is the cost of preferred stock?

Cost of Preferred Stock

Example 1

• In this case, we have the following data:

• Dividends (Dp) = $8.70
• Net Proceeds (Np) = $82 [=$87 – $5]
• Therefore, the cost of preferred stock will be:
• rP = DP/Np = $8.70/$82 = 10.60%

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Constituents of the WACC

Cost of Equity

Cost of Equity

• The cost of common stock is the return required by investors in

the market place.
• There are two forms of common stock financing:
• Retained Earnings
• New Issues of Common Stock

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Cost of Equity

• The firm’s equity weight is multiplied by either the cost of retained

earnings or the cost of new common stock in the WACC formula.
• The cost used depends on whether the firm’s equity will be
financed by using retained earnings or new issue.

Cost of Equity
Cost of Retained Earnings

• Following techniques are used to compute the cost of retained

earnings:
• Constant-growth dividend discount model
• Capital asset pricing model (CAPM)

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Cost of Equity
Cost of Retained Earnings

• The constant-growth dividend discount model assumes that

the value of a stock (P0) is equal to the present value of infinite
future dividends (D1, D2, D3, ….). These dividends are assumed to
grow at a constant rate (g) forever.

Cost of Equity
Cost of Retained Earnings

• According to the constant-growth dividend discount model, the

cost of retained earnings can be computed by solving the following
equation for ‘r’. In the following equation, ‘r’ is the cost of retained
earnings.
D1
P0 
r  g 
D
 r  1 g
P0

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Cost of Equity
Cost of Retained Earnings: Example 1

• ADA Corporation wishes to determine its cost of retained earnings.

The market price (P0) of its common stock is $50 per share. The
firm expects to pay a dividend (D1) of $4 at the end of the coming
year, 2013.

Cost of Equity
Cost of Retained Earnings: Example 1

• If the dividends paid on the outstanding stock over the past 6

years (2007–2012) were as follows, what should be the cost of
retained earnings?

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Cost of Equity
Cost of Retained Earnings: Example 1

• We can calculate the annual rate at which dividends have grown

(g) from 2007 to 2012. It turns out to be approximately 5% (more
precisely, it is 5.05%).
Years Growth
2012 0.049724
2011 0.043228
2010 0.042042
2009 0.067308
2008 0.050505

Average 0.050561

Cost of Equity
Cost of Retained Earnings: Example 1

• Given that D1 = $4, P0 = $50, and g = 5%, cost of retained earnings

can be computed as follows:
•r = ($4/$50) + 0.05
= 0.08 + 0.05
= 0.130 = 13.0%

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Cost of Equity
Cost of Retained Earnings

• Capital Asset Pricing Model (CAPM) is another widely used tool

to compute the cost of retained earnings. According to the CAPM:
• Expected Return = Rf + β(RMkt – Rf)
• In the equation of CAPM, Rf is the risk-free rate, β is the beta of
stock, RMkt is the return of the market index, and (RMkt – Rf) is the
market risk premium.

Cost of Equity
Cost of Retained Earnings: Example 2

• ADA Corporation wishes to calculate its cost of retained earnings

(rs) by using the CAPM. The firm’s investment advisors indicate
that the risk-free rate (Rf) equals 7%, the firm’s beta (β) equals 1.5,
and the market risk premium (RM - Rf) equals 4%. What is cost of
retained earnings?

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Cost of Equity
Cost of Retained Earnings: Example 2

• According to the CAPM, cost of retained earnings can be computed

as follows:
• rs = 7.0% + [1.5 * (11.0% – 7.0%)]
= 7.0% + 6.0%
= 13.0%

Cost of Equity
Cost of Retained Earnings

• The CAPM technique differs from the constant-growth dividend

discount model in that it directly considers the firm’s risk (as
reflected by beta) in determining the required return or cost of
retained earnings.
• The constant-growth dividend discount model does not look at
risk. It uses the market price, P0, as a reflection of the expected
risk–return preference of investors in the marketplace.

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Cost of Equity
Cost of Retained Earnings

• The constant-growth dividend discount model and the CAPM

techniques for finding cost of retained earnings are theoretically
equivalent, though in practice estimates from the two methods do
not always agree.

Cost of Equity
Cost of Retained Earnings

• Another difference between the two techniques is that when the

constant-growth dividend discount model is used to find the cost
of retained earnings, it can easily be adjusted for flotation costs to
find the cost of new common stock. The CAPM does not provide a
simple adjustment mechanism.

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Cost of Equity
Cost of Retained Earnings

• The difficulty in adjusting the cost of retained earnings calculated

by using the CAPM occurs because in its common form the model
does not include the market price (P0) – a variable needed to make
such an adjustment.

Cost of Equity
Cost of Retained Earnings

• It is worth mentioning that it is not necessary to adjust the cost of

retained earnings for flotation costs because by retaining earnings,
the firm “raises” equity capital without incurring these costs.

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Cost of Equity
Cost of New Issue of Common Stock

• The cost of a new issue of common stock is the cost of equity,

net of underpricing and associated flotation costs.
• NOTE: New shares are underpriced if the stock is sold at a price below its
current market price, P0.

Cost of Equity
Cost of New Issue of Common Stock

• If we assume that Nn represent the net proceeds from the sale of

new common stock after subtracting the underpricing and
flotation costs, the cost of the new issue can be expressed as
follows:
D1
r g
Nn

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Cost of Equity
Cost of New Issue of Common Stock

• The net proceeds from sale of new common stock (Nn) will be less
than the current market price (P0). Therefore, the cost of new
issues will always be greater than the cost of existing issues
which is equal to the cost of retained earnings.

Cost of Equity
Cost of New Issue of Common Stock: Example 1

• To determine its cost of new common stock, ADA Corporation has

estimated that new shares can be sold for $47. The $3-per-share
underpricing is due to the competitive nature of the market. A
second cost associated with a new issue is flotation costs of $2.50
per share that would be paid to underwriters. What is the cost of
new issue of common stock? Assume first future dividend of $4
and perpetual growth rate of 5% for dividends.

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Cost of Equity
Cost of New Issue of Common Stock: Example 1

• The total underpricing and flotation costs per share are $5.50
(=$3+$2.5). The actual price of the share is $50 (=$47+$3).
• As a result, cost of new common stock will be:
•r = ($4.00/$44.50) + 0.05
= 0.09 + 0.05
= 0.140 = 14.0%

Constituents of the WACC

Problems

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Problems
Example 1

• The total market value of ADA Corporation’s stock is $6 million,

and the total value of its debt is $4 million.
• The analyst estimates that the beta of stock is 1.2 and the expected
risk premium of the market is 10%. The T-bill rate is 4%.

Problems
Example 1

• What is required rate of return on ADA Corporation’s equity?

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Problems
Example 1

• The required rate of return on ADA Corporation’s equity is

computed as follows:
• Required Return = Rf + β*(Rm – Rf)
= 4% + 1.2 * 10% = 16%

Problems
Example 1

• What is the beta of company’s existing portfolio of assets? The

debt is perceived as risk-free.

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Problems
Example 1

• The beta of company’s existing portfolio of assets can be estimated

as follows:
• βPortfolio = (Fraction of portfolio in debt * Beta of debt) + (Fraction of
portfolio in equity * Beta of equity)
= (0.4 * 0) + (0.6 * 1.2) = 0.72

Problems
Example 1

• Estimate the weighted-average cost of capital. Assume a tax rate of

40%.

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Problems
Example 1

• The weighted-average cost of capital can be computed as follows:

D  E 
WACC   * R debt * (1  TC )    * R equity 
V  V 
WACC  0.4 * 4% * 1  0.4   0.6 *16%   10.56%

Problems
Example 1

• Estimate a discount rate for an expansion of company’s existing

business.

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Problems
Example 1

• If the company plans to expand its present business, then the

WACC is a reasonable estimate of the discount rate since the risk of
the proposed project is similar to the risk of the existing projects.
In this case, use a discount rate of 10.56%.

Problems
Example 1

• Suppose a company wants to diversify into the manufacture of

rose-colored glasses. The beta of optical manufacturers with no
debt outstanding is 1.4. What is the required rate of return on ADA
Corporation’s new venture? Assume that no new debt can be
issued.

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Problems
Example 1

• The WACC of optical projects should be based on the risk of those

projects. Using a beta of 1.4, the discount rate for the new venture
can be computed as follows:
• Required Return = Rf + β*(Rm – Rf)
= 4% + 1.4 * 10% = 18%

Constituents of the WACC

References

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References

• Brealey, R.A., Myers, S.C., and Allen, F., (2020). Principles of

Corporate Finance (Chapter 9). 13th Edition, McGraw-Hill.
• Gitman, L.J. and Zutter, C.J., (2012). Principles of Managerial
Finance (Chapter 9). 13th Edition, Pearson Prentice Hall.

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