A corporation's cost structure is its total financing from a combination of debt and equity. Management must determine the optimal mix of debt and equity that will help it to operate efficiently. The Weighted Average Cost of Capital (WACC) is the formula used to calculate the cost of capital to see whether management should take on specific investment projects. To maximise shareholder value, a corporation should only pursue investment projects that provide a return above its WACC.
Obtain the market value of corporate bonds and corporate tax rate for the debt calculation portion of WACC. To get corporate bond quotes, go to the Yahoo Finance website (see Resources) and type in the name of the company. To find the corporate tax rate, go to the company's financial statements.
Calculate the yield to maturity (YTM) on corporate bonds. For example, ABC company has 10,000 bonds outstanding selling at 97.5. The bonds pay 8 per cent year with interest paid semi-annually. The bonds have four years until maturity. Using a financial calculator to plug in the required inputs to get YTM. In this case:
PV = 9,750,000 (10,000 bound * 0.975 * £650)
PMT = -400,000 (-10,000,000 (principal to be paid back) * 8 per cent/2)
FV = -10,000,000
N = 8 (number of interest payments until maturity)
For ABC Company, the yield to maturity (i) = 8.45 per cent (4.22 per cent * 2).
Calculate the market value of equity by multiplying the number of shares outstanding times the current stock price. If ABC Company has 5,000,000 shares outstanding and its stock is selling at £7, then the market value of equity is £39,000,000. Therefore, the company's total capital structure is £45,175.000 (£39,000,000 + £6,337,500).
Use the Capital Asset Pricing Model formula: rE = rf + β(rm - rf) to derive the company's cost of equity, where:
rf = risk-free rate of return (use the yield on Treasury security)
β = beta (the correlation of the stock's risk to overall stock market risk)
rM = expected stock market return
Given ABC company's beta of 1.5, a risk-free rate of 4.8 per cent, and expected market return of 15 per cent, ABC's cost of equity is 20.1 per cent (4.8 + 1.5 *(15-4.8).
Plug in the various inputs for debt and equity into the WACC formula. The formula for WACC is: rD (1- Tc )( D / V )+ rE ( E / V ).
rD = yield to maturity of corporate debt
Tc = corporate tax rate
D = market value of corporate debt
V = total market value of debt + equity
rE = rate of return on equity
E = market value of equity
ABC Company's WACC is 18.1 per cent, calculated as follows: 8.45_(1 - 0.35) * (9,750,000/69,750,000) + 20.1_(60,000,000/69,750,000).
Given a WACC of 18.1 per cent, the management of ABC Company should only undertake investment projects with a rate of return above 18.1 per cent to maximise shareholder value. Earning a consistent return above its WACC should be produce a higher share price for the company. Conversely, undertaking projects with a lower rate of return than 18.1 per cent is taking away from shareholder value.
Tips and warnings
- Given a WACC of 18.1 per cent, the management of ABC Company should only undertake investment projects with a rate of return above 18.1 per cent to maximise shareholder value. Earning a consistent return above its WACC should be produce a higher share price for the company. Conversely, undertaking projects with a lower rate of return than 18.1 per cent is taking away from shareholder value.
Things you need
- Financial calculator