Weighted Average Cost of Capital (WACC) - Capital Structure of Corporations
Corporations need money daily to finance their operating activities, embark on investment activities and pay taxes, interest expense, etc. If you recall the chapter on valuing stocks, we said corporations can raise capital in 2 ways:
1) Bonds (debt financing)
What if a corporation does both of these? It can
issue bonds (which are a source of debt) and more common shares (which
is a source of equity). But what's the right mix between the two? How
much debt and how much equity should
a company carry? We answer this question next:
The amount of debt and equity that a company must maintain can be calculated via the WACC.
Weighted Average Cost of Capital (WACC) is therefore an overall return that a corporation MUST earn on its existing assets and business operations in order to increase or maintain the current value of the current stock. For example, if Microsoft's WACC is 15% and current stock price is 28$, then the company must earn a 15% return on its existing assets and business operations (net income) in order to MAINTAIN the stock price at $28. The last thing that corporations would wish to happen is their stock price falling down!
Weighted Average Cost of Capital (WACC) Formula
The formula for WACC is:
[Rd x D/V x (1-5)] + [Re x E/V]
Rd = Bond's yield to Maturity
(I/Y in Calculator)
Weighted Average Cost of Capital (WACC) Example
Coco Corp. has issued 10,000 units of bonds that are currently selling at 98.5. The coupon rate on these bonds is 6% per annum with interest paid semi-annually. The maturity left on these bonds is 3 years.
The company has 2,000,000 common shares outstanding with the current stock price at $10 / share. The stock beta is 1.5, risk free rate for government bonds is 4.5% and the Expected Return on the Stock Market is 14.5%.
The tax rate for the corporation is 30%
V = Total Capital Structure
Summary of Important Terms
Rd = 6.56% = 0.0656
Re = 0.195
WACC = [Rd x D/V x (1-5)] + [Re x E/V]
[(0.0656) (0.33) (0.7)] + [(0.195) (0.67)]
Interpretation of WACC
A WACC of 14.58% means Coco Corp. must earn a return of 14.58% on all its assets and business operations in order to MAINTAIN the current stock price at $10 per share. If Coco Corp. wants its stock price to go higher, it must achieve a return rate greater than 14.58%