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).