3/19/2017 Weighted 

Average Cost of Capital: Applications & Example ­ Equity Investments: CFA Level 2 Tutorial | Investopedia

Topics Reference Advisors Markets Simulator

Search News, Symbols, Terms Newsletters

Weighted Average Cost of Capital: Applications &

Example
By Elvin Mirzayev, CFA, FRM SHARE

You May Also Like: Learn how to retire in style using 401k tips, IRA tricks, tax savings and more...

Study Session For Equity: Part I Study Session For Equity: Part II Study Session For Equity: Part III

1. Equity Valuation: Its Applications

2.2 Required Return, Discount Rate and IRR: Concepts & Examples
and Processes
2.3 Equity Risk Premium: Applications and Real Life Examples
2. Return Concepts for Equity
2.4 Required Rate on Equity: CAPM, Fama-French & Build-up Model
Valuation
2.5 Weighted Average Cost of Capital: Applications & Example

2.6 Summary of Return Concepts for Equity Valuation

Which discount rate must be used in valuing company projects? There can be different approaches
in answering this question. One of the approaches is weighted average cost of capital (WACC).
(WACC). In
practice, companies are rarely all equity financed. The majority of companies have at least two
sources of fund suppliers: common equity holders and lenders of debt. Some companies also use
preferred stock in their balance sheet. In general terms, WACC for a company will be calculated as
follows:

WACC = Wd x Rd x (1-T) +We x Re+Wp xRp

Where notations Wd ,We ,Wp denote weight of debt, common equity and preferred equity,
respectively. Rd , Re and Rp represent cost of debt, common equity and preferred equity, respectively.
T is the tax rate and is included in the formula to take into account tax shield and tax savings
resulting from tax deductibility of interest on debt. One of the most important rules in WACC
estimation is taking into account only market values of each fund calculation.
Frequently Asked Questions
Example for WACC: How did George Soros "break the Bank of England"?

What counts as "debts" and "income" when calculating

Suppose that General Motors (GM) has common equity of $35.5 billion and $31.9 billion of long
my debt-to-income (DTI) ratio?
term debt and $10.3 billion of preferred equity on its books. Required return on these funds are
12%, 8%, and 10%, respectively. Market values of the common equity and long term debt are $46.6 Who are Monsanto's main competitors?
billion and $35 billion, respectively. Market value of preferred equity is the same as its book value.
Why Do Most of My Mortgage Payments Start Out as
Estimate WACC for the company given that its effective tax rate is 30%. Interest?

Solution:

In order to estimate WACC, we first need to identify the market value of funds and their respective
weights:

Common equity - $46.6 billion

http://www.investopedia.com/study­guide/equity­investments­cfa­level­ii­tutorial/study­session­equity­part­i/return­concepts­equity­valuation/weighted­average… 1/4
3/19/2017 Weighted Average Cost of Capital: Applications & Example ­ Equity Investments: CFA Level 2 Tutorial | Investopedia

Preferred equity - $10.3 billion

Topics Reference Advisors Markets Simulator

Long term debt - $35 billion

Search News, Symbols, Terms Newsletters

Total capital - $91.9 billion

WACC = 46.6/91.9 x 12% + 35/91.9 x 8% x (1-30%) + 10.3/91.9 x 10% = 9.34%

Note that the weight for each capital is estimated as the value of each capital divided by the total
capital.

WACC application is accurate only when the project is as risky as the overall company.

WACC or the firm’s cost of capital is appropriate to use when free cash flows to the firm (FCFF) are to
be discounted. Free cash flows to the firm are cash flows that can be distributed to all capital
providers of the firm: both equity holders and debt holders. However, if a valuator uses cash flow
available to common equity holders, then the required return on equity is an appropriate discount
rate for discounting these cash flows. (For a quick review on FCFF, see Understanding Free Cash Flow)
Flow)

Note that we may have to deal with nominal cash flows, which are not adjusted for inflation, or real
cash flows, which are adjusted for inflation. For consistency when we discount nominal cash flows
we should use nominal interest rates. Conversely, when we discount real cash flows we should use
real interest rates. As a result, the present value of an investment is independent of the expected
inflation rate.
Trading Center
Example for discounting nominal and real cash flows:ve $10 000 at the end of each year. These cash
flows are nominal cash flows because, they are not adjusted for inflation, thus we use nominal
interest rate of 10% to find the present value (PV) of the cash flows.

Suppose you have made an investment expect to receive net cash flow of $30 000 in three equal
installments ($10,000) at the end of each year over the next three years. Currently nominal interest
rate which is also your opportunity cost of capital is 10% and you expect annual inflation rate to be
3% over the next three years. What is the present value of these cash flows in nominal and real Partner Links
terms.
Learn to trade stocks by investing $100,000 virtual
dollars...
Nominal cash flow discounting: We know that over the next three years we are going to receive:

PV (nominal) = $10 000/1.10 + $10 000/1.12 + $10 000/1.13 =$24,869

Real cash flow discounting: We are expecting the prices to increase, thus the purchasing power of
each $10,000 will not be the same. For example, in the first year you can buy 10 laptops worth
$1,000 each. If the price of a laptop increases by 3% to $1,030 at the end of the second year, we can
no longer purchase 10 laptops and, when laptop prices increase by the same amount in the 3rd
year to $1,060.90, we can purchase even fewer laptops.

Thus, the real value of cash flows is found by adjusting nominal cash flows for the inflation rate as
follows: 10,000/1.03 = $9,709 for the first year, $10,000/1.032 = $9,426 for the second year and
$10,000/1.033 = $9,151.4 for the third year. (see below the table)

Cash flows 1st year 2 nd year 3rd year

Nominal cash flows $10,000 $10,000 $10,000
Real values of cash flows $ 9,709 $9,426 $ 9,151
When we discount these cash flows, we need to estimate real interest rates using the following
formula:

http://www.investopedia.com/study­guide/equity­investments­cfa­level­ii­tutorial/study­session­equity­part­i/return­concepts­equity­valuation/weighted­average… 2/4
3/19/2017 Weighted Average Cost of Capital: Applications & Example ­ Equity Investments: CFA Level 2 Tutorial | Investopedia

Rr =(1+Rn) / (1+i) -1 = (1+10%) / (1+3%) - 1 ≈ 6.8%

Topics Reference Advisors Markets Simulator

Eventually we discount real cash flows by real discount rates:

Search News, Symbols, Terms Newsletters

PV (real) = $9,709 /1.068 + $9,426/1.0682 +$9,151/1.0683 = $24,869

Thus, the PV of real and nominal cash flows are the same. (note: we have ignored rounding effects
in real cash flow discounting)

(For more on the cost of capital, read Cost Of Capital - Weighted Average Cost Of Capital)
Capital)

Want to Learn to Trade Options Like a Day Trader?

Options can fit a range of investing goals whether it's maximizing your exposure or helping to
minimize your risk. If you want to learn everything you need to know about trading them, then sign
up for our free 8-week email course. Twice a week you'll receive an email that will take you from not
knowing what an option is, to how you can trade them within your brokerage account. So sign up for
free and start learning how you can add options to your investing toolkit.
 

Next: Summary of Return Concepts for Equity Valuation

RELATED ARTICLES
INVESTING
Investors Need A Good WACC
Weighted average cost of capital may be hard to calculate, but it's a solid way to
measure investment quality.

INVESTING
Free Cash Flow Yield: A Fundamental Indicator
Free cash flow can measure a business’s performance as if you’re looking at its
net income line.

INVESTING
Operating Cash Flow: Better Than Net Income?
Differences between accrual accounting and cash flows show why net income is
easier to manipulate.

INVESTING
Valuing Firms Using Present Value Of Free Cash Flows
When trying to evaluate a company, it always comes down to determining the
value of the free cash flows and discounting them to today.

INVESTING
Cash Flow Statement: Analyzing Cash Flow From Financing
Activities
The financing activity in the cash flow statement measures the flow of cash
between a firm and its owners and creditors.

http://www.investopedia.com/study­guide/equity­investments­cfa­level­ii­tutorial/study­session­equity­part­i/return­concepts­equity­valuation/weighted­average… 3/4
3/19/2017 Weighted Average Cost of Capital: Applications & Example ­ Equity Investments: CFA Level 2 Tutorial | Investopedia
SMALL BUSINESS
Topics
Understanding Reference
Cash Flow Advisors Markets Simulator
Learn about the different types of cash flows and the importance for businesses
to properly manage their cash flows. Search News, Symbols, Terms Newsletters

Search Investopedia

DICTIONARY: # A B C D E F G H I J K L M N O P Q R S T U V W X Y

CONTENT LIBRARY CONNECT WITH INVESTOPEDIA

Articles Terms
Stock Simulator
Videos
FXtrader
Guides Slideshows
Exam Prep Quizzer
FAQs Calculators
Net Worth Calculator
Chart Advisor Stock Analysis
HcrIJ
WORK WITH INVESTOPEDIA GET FREE NEWSLETTERS
About Us Advertise With Us Write For Us Contact Us Careers Newsletters

© 2017, Investopedia, LLC. All Rights Reserved Terms Of Use Privacy Policy

http://www.investopedia.com/study­guide/equity­investments­cfa­level­ii­tutorial/study­session­equity­part­i/return­concepts­equity­valuation/weighted­average… 4/4