20

The Cost of Capital with Debt
•
The Weighted Average Cost of Capital (WACC) is given by
•
Because interest expense is tax-deductible, we multiply
the last term by (1 –
T
C
)
r
WACC
=
Equity + Debt
Equity
×
r
Equity
+
Equity + Debt
Debt
× r
Debt
×(1 –
T
C
)
r
WACC
=
S
+
B
S
×
r
S
+
S
+
B
B
× r
B
×(1 –
T
C
)
21

WACC Calculation
•
First, we estimate the cost of equity and the cost of debt
–
We estimate an equity beta to estimate the cost of equity
–
We can often estimate the cost of debt by observing the YTM
of the firm’s debt
•
Second, we determine the WACC by weighting these two
costs appropriately
22

Example: International Paper (1/2)
•
The industry average beta is 0.82; the risk free
rate is 3%; and the market risk premium is 8.4%
•
Calculate the cost of equity capital
23
R
S
=
R
F
+
β
i
× (
R
M
–
R
F
)
= 3% + 0.82×8.4%
= 9.89%

Example: International Paper (2/2)
•
The yield on the company’s debt is 8%, and the firm has a
37% marginal tax rate
•
The debt to value ratio is 32%
•
Calculate WACC
•
Note:
–
8.34% is International’s cost of capital
–
It should be used to discount any project where one believes that the
project’s
risk
is equal to the risk of the firm as a whole and the project has
the same
leverage
as the firm as a whole
24
= 0.68 × 9.89% + 0.32 × 8% × (1 – 0.37)
= 8.34%
r
WACC
=
S
+
B
S
×
r
S
+
S
+
B
B
×
r
B
×(1 –
T
C
)

WACCs for Real Companies
25
The cost of equity is computed using the company’s equity beta, a risk-free
rate of 3%, and a market risk premium of 6%. The cost of debt is taken from
the company’s debt. The percent equity and percent debt are determined
from the company’s market capitalization and balance sheet in 2010. The tax
rate is 35%.
Source: Berk, DeMarzo, and Harford (2011).

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- Spring '08
- SMITH
- Finance, Corporate Finance, Cost Of Capital, Weighted average cost of capital, Equity Capital