Calculating the Weighted Average Cost of Capital (WACC)

Jul 7, 2024

Lecture Notes: Calculating the Weighted Average Cost of Capital (WACC)

Introduction

  • Topic: Building on previous tutorial to calculate the weighted average cost of capital (WACC) for a firm.
  • Focus: Calculation of the cost of the firm’s debt and integrating it into WACC.
  • Purpose of WACC: To find the average funding cost for the firm which is used as a discount rate for projects or valuing the entire firm.

Key Concepts

  • Cost of Equity: Previously calculated using the Gordon Dividend Formula in an earlier tutorial.
  • WACC: The discount rate that incorporates the average cost of both equity and debt.
    • Formula: Combines the required return from both shareholders (equity) and debt holders.

Steps to Calculate WACC

  1. Calculate the Cost of Debt
  2. Determine the Tax Rate
  3. Combine the Calculated Cost of Debt and Equity to find WACC

Detailed Steps

1. Calculating the Cost of Debt

  • Required Data:
    • Amount of debt (found in the balance sheet).
    • Interest payments (found in the income statement).
  • Case Study: The Gap
    • Fiscal year ending January 27, 2012.
    • Debt Data:
      • Short-term debt for 2012: $59,000 (in thousands = $59,000,000).
      • Long-term debt for 2012: $1,066,000 (in thousands = $1,066,000,000).
    • Interest Expense (from the income statement): $74,000 (in thousands = $74,000,000).
  • Interest Rate Formula: Interest expense divided by average debt.
  • Result: Cost of debt for The Gap was calculated as 8.87%.

2. Determining the Tax Rate

  • Data Required:
    • Income before tax (taxable income).
    • Income tax expense.
  • Case Study Values:
    • Income before tax (2012): $1,369,000 (in thousands = $1,369,000,000).
    • Income tax expense (2012): $536,000 (in thousands = $536,000,000).
  • Tax Rate Calculation: Tax rate = Income tax expense / Income before tax.
    • Result: Tax rate for The Gap was calculated as 39%.

3. Calculating the Weighted Average Cost of Capital (WACC)

  • Components Needed:

    • Cost of equity (previously calculated as 15.59%).
    • Cost of debt (8.87%).
    • Number of shares outstanding: 579,015 (from Yahoo Finance 'Key Statistics').
    • Current share price: $32.50.

  • Formulas:

    • Market Value of Equity: Shares outstanding multiplied by current share price.
    • Market Value of Debt: Summation of short-term and long-term debt.
    • Total Equity + Debt (External Funds): Market value of equity + Market value of debt.
    • Percentage of Equity: Market value of equity / Total external funds.
    • Percentage of Debt: Market value of debt / Total external funds.
    • Adjust percentages to ensure they sum to 100%.

  • WACC Calculation:

    • Formula:
      • WACC = (Cost of debt × % of debt × (1 - Tax rate)) + (Cost of equity × % of equity).
    • Result for The Gap: WACC was calculated as 14.6%.

Conclusion

  • Final WACC: 14.6%
  • Application: This rate can be used for future project evaluations and firm valuation.