ࡱ>   \p Ian Giddy Ba==Ku08X@"1DArial1DArial1DArial1DArial1 DArial1DArial1DArial1 DArial1DArial1DArial1DArial1 DArial1DArial1DVerdana1$DArial"$"#,##0_);\("$"#,##0\)!"$"#,##0_);[Red]\("$"#,##0\)""$"#,##0.00_);\("$"#,##0.00\)'""$"#,##0.00_);[Red]\("$"#,##0.00\)7*2_("$"* #,##0_);_("$"* \(#,##0\);_("$"* "-"_);_(@_).))_(* #,##0_);_(* \(#,##0\);_(* "-"_);_(@_)?,:_("$"* #,##0.00_);_("$"* \(#,##0.00\);_("$"* "-"??_);_(@_)6+1_(* #,##0.00_);_(* \(#,##0.00\);_(* "-"??_);_(@_)=8_("$"* #,##0.0_);_("$"* \(#,##0.0\);_("$"* "-"??_);_(@_)4/_(* #,##0.0_);_(* \(#,##0.0\);_(* "-"??_);_(@_) 0.0%3._(* #,##0.0_);_(* \(#,##0.0\);_(* "-"?_);_(@_)0.000000000000000%"Yes";"Yes";"No""True";"True";"False""On";"On";"Off"],[$ -2]\ #,##0.00_);[Red]\([$ -2]\ #,##0.00\)                + ) , *     @@  $@   $ @  @ a $    @   @ ! $  $  $ a , @ a , 8@@ 8@     ,@ @   ,@  (@   ,@  ,@ ,! (@ ! ,@  @ a $ a ,@    @ ( ( )  (     *x""6  )x""6 Q p""* Q p""* p""* Q p"" Qp"" p"" Qp""* Qp" Qp" Qp"        @ @ "4@ @  (@ @ "<@ @  `@ @  "t@ @   ( "8@@ "8@ "8 @ 8@@ 8@ 8@ 8 8@ 8 Q p" Q p" Q p"  p" p" p"     `\ WACC Tutorial oWACC{Industry BetasData from Damodaran  ;" Risk free rate (%)Equity risk premium (%)Corporate tax rate (%)Yield-to-Maturity of debt (%)Share price ($)Common shares (MM)Market value of debt ($, MM)Pre-tax cost of debt (%)After-tax cost of debt (%)Cost of equity (%)DebtEquityMarket value of equity ($, MM)TotalEnterprise Value ($, MM)Percent of enterprise value (%)*Weighted Average Cost of Capital (WACC, %)Inputs for WACC Calculation:3Weighted Average Cost of Capital (WACC) Calculation!What Does "Cost of Capital" Mean?Let's dissect this definition:AHow Do We Calculate a Company's Weighted Average Cost of Capital?QWe calculate a company's weighted average cost of capital using a 3 step process:However, we are not done yet. We noted above that we have to adjust for the tax-deductibility of interest expenses, which lowers the cost of debt according to the following formula:nTo calculate any company's cost of equity capital, we need to find a reliable source for each of these inputs:Sources for this include:eThere are a variety of sources available for obtaining the beta coefficient for a particular company.uOpportunity cost is what you give up as a consequence of your decision to use a scarce resource in a particular way. KAll capital invested is the total amount of cash invested into a business. 1. Cost of capital components. First, we calculate or infer the cost of each kind of capital that the enterprise uses, namely debt and equity.A. Debt capital. The cost of debt capital is equivalent to actual or imputed interest rate on the company's debt, adjusted for the tax-deductibility of interest expenses. Specifically:sThe after-tax cost of debt-capital = The Yield-to-Maturity on long-term debt x (1 minus the marginal tax rate in %)^B. Equity capital. Equity shareholders, unlike debt holders, do not demand an explicit return on their capital. However, equity shareholders do face an implicit opportunity cost for investing in a specific company, because they could invest in an alternative company with a similar risk profile. Thus, we infer the opportunity cost of equity capital.We can do this by using the "Capital Asset Pricing Model" (CAPM). This model says that equity shareholders demand a minimum rate of return equal to the return from a risk-free investment plus a return for bearing extra risk. This extra risk is often called the "equity risk premium", and is equivalent to the risk premium of the market as a whole times a multiplier--called "beta"--that measures how risky a specific security is relative to the total market.UThus, the cost of equity capital = Risk-Free Rate + (Beta times Market Risk Premium).2. Capital structure. Next, we calculate the proportion that debt and equity capital contribute to the entire enterprise, using the market values of total debt and equity to reflect the investments on which those investors expect to earn a minimum return.3. Weighting the components. Finally, we weight the cost of each kind of capital by the proportion that each contributes to the entire capital structure. This gives us the Weighted Average Cost of Capital (WACC), the average cost of each dollar of cash employed in the business.y1. Cost of capital components. Gateway draws upon two major sources of capital from the capital markets: debt and equity.jAfter-Tax Cost of Debt Capital = The Yield-to-Maturity on long-term debt x (1 minus the marginal tax rate)KCost of Equity Capital = Risk-Free Rate + (Beta times Market Risk Premium).Yahoo. Yahoo offers free beta estimates through its Company Profile service. Click here to see Gateway's Company Profile on Yahoo. Bloomberg. Free beta estimates from Bloomberg can be accessed online. Bloomberg's estimate of Gateway's current beta can be accessed here. qFor those interested in looking at historical equity risk premia, we refer you to the following online resources:3. Weighting the components. Finally, we weight the cost of each kind of capital by the proportion that each kind of capital contributes to the entire enterprise. This gives us the Weighted Average Cost of Capital (WACC), the average cost of each dollar of cash employed in the business.In an enterprise this refers to the fact that we are measuring the opportunity cost of all sources of capital which include debt and equity.`"Cost of capital" is defined as "the opportunity cost of all capital invested in an enterprise."$The Weighted Average Cost of Capital`To demonstrate how to calculate a company's cost of capital, we will use the Gateway case study. Data SetsDownload Excel file Archived Data DescriptionDownload71998, 1999, 2000, 2001, 2002, 2003 , 2004 , 2005 , 2006=Historical Returns on Stocks, Bonds and Bills - United StatesThis data set includes actual returns on stocks, bonds and bills for the United States from 1928 to the most recent year. It is a useful starting point for estimating historical equity premiums.,Implied Equity Risk Premiums - United States Download These risk premiums are estimated based upon a simple 2-stage Dividend discount model and reflect the risk premium which would justify they current level of the index, given the dividend yield, expected growth in earnings and the level of the long term bond rate.Risk Premiums for Other Markets)2000, 2001, 2002, 2003, 2004, 2005 , 2006sThese are risk premiums estimates for other markets based upon the country ratings assigned by Standard and Poors'.'Levered and Unlevered Betas by IndustryU.S. EuropeJapan Emerg Mkt61998, 1999, 2000, 2001, 2002, 2003. 2004 , 2005 , 2006This data set lists betas by industrial sector. The betas are computed using 5 years of monthly returns for each stock and then averaged (simple). The unlevered betas are estimated using the average market debt/equity ratios by industrial sector. (Hamada betas).Marginal tax rate by countryThis is the KPMG survey of corporate tax rates by country. Please give them full credit when you use any of the information from this file.Total Beta By Industry Sector61998, 1999, 2000, 2001, 2002, 2003, 2004 , 2005 , 20060These are betas adjusted to reflect a firm's total exposure to risk rather than just the market risk component. It is a function of the market beta and the portion of the total risk that is market risk. These betas might provide better estimates of costs of equity for undiversified owners of businesses."Risk Measures by Market Cap Class These are risk measures - standard deviatiions, betas, total betas and hilo risk - broken down for U.S. firms into ten market cap classes. Make of it what you will.#Costs of Capital by Industry SectorqThis data set lists costs of equity, costs of debt, market debt ratios and costs of capital by industrial sector./From Aswath Damodaran's web site, damodaran.comDataCable TVCoalHuman ResourcesPharmacy ServicesPrecious MetalsSemiconductor EquipmentTobacco=Industry Betas (these data can be updated from damodaran.com)IndustryBetaAdvanced Materials/PrdAdvertising AgenciesAdvertising SalesAdvertising ServicesAerospace/DefenseAerospace/Defense-EquipAgricultural BiotechAgricultural ChemicalsAgricultural OperationsAir Pollution Control EqAirlinesAirport Develop/MaintApparel Manufacturers AppliancesApplications SoftwareAthletic EquipmentAthletic FootwearAudio/Video ProductsAuto Repair CentersAuto-Cars/Light TrucksAuto-Med&Heavy Duty TrksAuto/Trk Prts&Equip-OrigAuto/Trk Prts&Equip-ReplB2B/E-CommerceBatteries/Battery SysBeverages-Non-alcoholicBeverages-Wine/SpiritsBicycle ManufacturingBldg Prod-Air&HeatingBldg Prod-Cement/AggregBldg Prod-Doors&WindowsBldg Prod-WoodBldg-Mobil Home/Mfd HousBldg-Residential/CommerBldg&Construct Prod-MiscBlood Collection BankingNABreweryBroadcast Serv/ProgramBuilding-Heavy ConstructBuilding-Maint&ServiceBuilding&Construct-Misc Capacitors Casino HotelsCasino ServicesCellular TelecomCeramic ProductsChemicals-DiversifiedChemicals-FibersChemicals-Other< Chemicals-PlasticsChemicals-SpecialtyCircuit BoardsCircuitsClosed-end FundsCoatings/PaintCoffee CollectiblesCommer Banks Non-USCommercial Serv-FinanceCommercial ServicesCommunications SoftwareComputer Aided DesignComputer Data SecurityComputer GraphicsComputer ServicesComputer Software ComputersComputers-Integrated SysComputers-Memory DevicesComputers-OtherComputers-Peripher EquipConsulting ServicesConsumer Products-MiscContainers-Metal/GlassContainers-Paper/PlasticCooperative BanksCosmetics&Toiletries Cruise LinesCrystal&GiftwareData Processing/MgmtDecision Support SoftwarDental Supplies&Equip DerivativesDiagnostic EquipmentDiagnostic KitsDiamonds/Precious StonesDirect MarketingDisposable Medical ProdDistribution/WholesaleDivers Oper/Commer ServDiversified Finan ServDiversified Manufact OpDiversified MineralsDiversified OperationsDrug Delivery SystemsE-Commerce/ProductsE-Commerce/ServicesE-Services/ConsultingEducational SoftwareElectric Products-MiscElectric-DistributionElectric-GenerationElectric-IntegratedElectric-TransmissionElectronic Compo-MiscElectronic Compo-SemiconElectronic ConnectorsElectronic Design AutomaElectronic Measur InstrElectronic Parts DistribElectronic Secur DevicesElectronics-MilitaryEnergy-Alternate SourcesEngineering/R&D ServicesEngines-Internal CombustEnterprise Software/ServEntertainment SoftwareEnviron Consulting&Eng ExplosivesExtended Serv ContractsFeminine Health Care PrdFiltration/Separat ProdFinance-Auto LoansFinance-CommercialFinance-Consumer LoansFinance-Credit CardFinance-Invest Bnkr/BrkrFinance-Investment FundFinance-Leasing CompanFinance-Mtge Loan/BankerFinance-Other ServicesFirearms&Ammunition Fisheries Food-Baking Food-Canned Food-CateringFood-ConfectioneryFood-Dairy ProductsFood-Flour&GrainFood-Meat ProductsFood-Misc/Diversified Food-RetailFood-Wholesale/DistribFootwear&Related ApparelForestryFuneral Serv&Rel ItemsGambling (Non-Hotel)Gas-DistributionGas-Transportation Gold MiningGolfHazardous Waste DisposalHealth Care Cost ContainHealthcare Safety DeviceHome Decoration ProductsHome FurnishingsHospital Beds/Equipment Hotels&Motels HousewaresIdentification Sys/Dev Import/ExportInactive/UnknownIndepend Power ProducerIndustr Audio&Video ProdIndustrial Automat/RobotIndustrial GasesInstruments-ControlsInstruments-ScientificInsurance BrokersInterior Design/ArchitecInternet Applic SftwrInternet BrokersInternet Connectiv SvcsInternet Content-EntmntInternet Content-Info/NeInternet GamblingInternet IncubatorsInternet Infrastr EquipInternet Infrastr SftwrInternet SecurityInternet TelephonyIntimate ApparelInvest Comp - ResourcesInvest Mgmnt/Advis ServInvestment CompaniesLasers-Syst/ComponentsLeisure&Rec ProductsLeisure&Rec/GamesLife/Health InsuranceLighting Products&SysLinen Supply&Rel ItemsLottery ServicesMach Tools&Rel ProductsMachinery-Constr&MiningMachinery-Electric UtilMachinery-ElectricalMachinery-FarmMachinery-General IndustMachinery-Material HandlMachinery-Print TradeMachinery-PumpsMachinery-Therml ProcessMarine ServicesMedical Imaging SystemsMedical Information SysMedical InstrumentsMedical Labs&Testing SrvMedical Laser SystemsMedical ProductsMedical Steriliz ProductMedical-Biomedical/Gene Medical-DrugsMedical-Generic Drugs Medical-HMOMedical-HospitalsMedical-Outptnt/Home MedMedical-Whsle Drug DistMetal Processors&FabricaMetal Products-DistribMetal Products-FastenersMetal-Aluminum Metal-CopperMetal-Diversified Metal-IronMining ServicesMiscellaneous ManufacturMoney Center BanksMortgage BanksMotion Pictures&ServicesMotorcycle/Motor ScooterMulti-line InsuranceMultilevel Dir Selling MultimediaMusicNetworking ProductsNon-Ferrous MetalsNon-hazardous Waste DispNot classifiedOffice Automation&EquipOffice Furnishings-OrigOffice Supplies&FormsOil Comp-Explor&ProdtnOil Comp-IntegratedOil Field Mach&EquipOil Refining&MarketingOil-Field ServicesOil&Gas DrillingOptical SuppliesPaper&Related ProductsPastoral&AgriculturalPatient Monitoring EquipPetrochemicalsPhoto Equipment&SuppliesPhys Practice Mgmnt PipelinesPlatinumPollution ControlPoultryPower Conv/Supply EquipPrinting-CommercialProfessional SportsProperty TrustProperty/Casualty InsProtection-SafetyPublic ThoroughfaresPublishing-BooksPublishing-NewspapersPublishing-Periodicals Quarrying RacetracksRadioReal Estate Mgmnt/ServicReal Estate Oper/DevelopRecreational Centers RecyclingRegional Banks-Non US ReinsuranceRemediation ServicesRental Auto/EquipmentResearch&DevelopmentResorts/Theme ParksRespiratory ProductsRetail-Apparel/ShoeRetail-AppliancesRetail-Auto PartsRetail-AutomobileRetail-BookstoreRetail-Building ProductsRetail-Catalog ShoppingRetail-Computer EquipRetail-Consumer ElectronRetail-Convenience StoreRetail-DiscountRetail-Drug StoreRetail-Hair SalonsRetail-Home FurnishingsRetail-HypermarketsRetail-JewelryRetail-Major Dept StoreRetail-Misc/DiversifiedRetail-Office SuppliesRetail-Perfume&CosmeticsRetail-Petroleum ProdRetail-Regnl Dept StoreRetail-RestaurantsRetail-Sporting GoodsRetail-Toy Store Rubber-TiresRubber/Plastic Products Rubber&VinylSatellite TelecomSchoolsSecurity ServicesSeismic Data CollectionSemicon Compo-Intg Circu Shipbuilding Silver MiningSoap&Cleaning PreparSpecial Purpose BanksSpecial Purpose EntitySpecified Purpose AcquisSteel Pipe&TubeSteel-ProducersSteel-Specialty StevedoringStorage/WarehousingSugarSuperconductor Prod&SysTanneryTeaTelecom Eq Fiber OpticsTelecom ServicesTelecommunication EquipTelephone-Integrated TelevisionTextile-ApparelTextile-Home FurnishingsTextile-ProductsTheaters TherapeuticsTools-Hand HeldToysTransactional SoftwareTransport-Air FreightTransport-Equip&LeasngTransport-MarineTransport-RailTransport-ServicesTransport-TruckTravel ServicesVenture CapitalVeterinary DiagnosticsVeterinary ProductsVitamins&Nutrition ProdWaterWater Treatment SystemsWeb Hosting/DesignWeb Portals/ISPWhsing&Harbor Trans ServWire&Cable ProductsWireless EquipmentWoolWound,Burn&Skin CareX-Ray Equipment1Case Study: Gateway Construction Pty Ltd. (India)?Please note that in this example, we have used a company's actual cost of debt as a proxy for its marginal cost of long-term debt. A company's marginal cost of long-term debt may be better estimated by summing the risk-free rate and the "credit spread" that lenders would charge a company with a specific credit rating.%FT.com - the Financial Times web site Reuters.comaTo continue with our Gateway case study, we used the following estimates for these three factors: By Ian GiddyXAcknowledgement: Adapted from http://www.expectationsinvesting.com/spreadsheets/WACC.xlsYIn addition to the calculated risk premium, additional required return may be needed for:!- Private equity illiquidity risk- Country risk~Ibbotson Associates. Ibbotson sells a report on historical risk premia over time on its website. The report can be purchased. Aswath Damodaran. Valuation expert Professor Damodaran of NYU's Stern School of Business has published data as well as an informative article on equity risk premia that can be downloaded free of charge.Beta of equity9- Minority shareholding/corporate governance risk premiumzA. Cost of debt capital. Gateway had debt of $8.5 million. Enter this figure in the appropriate cell of worksheet "WACC." /B. Cost of equity capital. We noted above that:M2. Beta coefficient. We enter this data po< int in cell C8 of worksheet "WACC.";Available as spreadsheet WACC_tutorial.xls on www.giddy.orgAWe enter the marginal corporate tax rate in the worksheet "WACC."Our first step in calculating any company's cost of capital is to consult the relevant annual report. This document tells us that Gateway has two components to its total debt of $8.5 million:Regular debt. Capital leases. Gateway also has "capital leases." A capital lease is a debt-like agreement in which a firm agrees to pay fixed amounts to someone who leases them land or equipment. \Given Gateway's marginal tax rate of 30%, the company's after-tax cost of debt equates to 11.5% x (100% minus 30%), or 8.1%. We see this calculation in the worksheet "WACC."YBecause there are two kinds of debt with different interest rates, we have to weight the different interest rates associated with each kind of debt by the relevant proportion of debt that each comprises. In this case, the weighted pre-tax cost of debt would be equivalent to 11.5%. Enter the pre-tax cost of debt in cell C5 of worksheet "WACC." 1. Risk-free Rate. We suggest using the rate of return on long-term (ten-year) US government treasury bonds as a proxy for the risk-free rate. (Or German Bunds for Euros). We enter this data point in cell C4 of worksheet "WACC."UDamodaran.com for industry betas - helpful for private companies and emerging marketsIn this case we have selected the industry beta for "Building - Heavy Construction" from the the worksheet "Industry Betas, obtained from damodaran.com. Enter 1.66 for Gateway's beta.]3. Equity Risk Premium. Forward looking approaches, as well as more recent historical data, suggest an equity risk premium in the 3 to 5 percent range. Additional factors can raise this, as noted below. We use an Equity Risk Premium estimate of 7.5% for this family-dominated Indian company. We enter this data point in cell C7 of worksheet "WACC." Risk-free rate of 4%. Beta coefficient of 1.66. Equity risk premium of 7.5%.Using these estimates, Gateway's cost of equity capital = Risk-Free Rate + (Beta times Market Risk Premium).= 4.00% + (1.66 x 7.5%), or 16.5%. We see this calculation in the results section of worksheet "WACC."To review, Gateway's after-tax cost of debt is 8.1% and its cost of equity is 16.5%. The market value of Gateway's debt is equal to $8.5 million and the market value of Gateway's equity is $45 million. The value of equity can be obtained from the shares outstanding and share price in cells C12 and C13 in worksheet "WACC." Alternatively, for private companies, the value of the business may be computed using comparables or a valuation model.Gateway's weighted average cost of capital is thus 8.1% x 15.9% + 16.5% x 84.1% = 15.1%. 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