 Hello and welcome to this session. This is Professor Farhad and this session we would look at the weighted average cost of capital or WACC. This topic is covered in corporate finance or introduction to finance course as well as the CPA BEC section. As always I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,700 plus accounting, auditing, finance and tax lectures as well as Excel tutorial. This is a list of all the courses that I cover. If you like my lectures please like them, share them, subscribe to the channel, put them in playlists. If they benefit you it means they might benefit other people, share the wealth and connect with me on Instagram. On my website farhadlectures.com you will find additional resources to supplement your finance as well as your accounting courses, your CPA exam, CMA exam as well. And by the way this topic also covered on the CMA exam. Let's start to talk about the weighted average cost of I'm going to take you back to basic accounting and this is going to help you tremendously in understanding this concept or this formula. Let's go back to the basic accounting equation and if you remember we state that assets equal to liabilities plus equity. Hopefully you remember this much from the accounting equation. Now we know that liabilities it's the same word we can substitute the liability with word debt because liabilities are debt. So in the finance language they use the word debt it's the same thing plus equity so far so good. Now also we know that we have short-term debt and we have long-term debt that's also we have that and under equity if you remember equity is composed mainly of retained earnings which is what the company earn and keeps and common stock plus preferred stock mainly there's there are other equity but they're not really a large component. So simply put assets equal to that much now if we value everything at market value if we value the debt at market value if you value the equity at market value that's going to give us the value of the company the value of the company equal to the value of the debt so this is fair market value plus the fair market value of equity right if the if assets equal to that plus equity it means the value of the asset the fair market value of the firm of the asset of the firm equal to the fair market value of the debt plus the fair market value plus fair market value of equity this is how it works. Now why is it why is it important to understand this here's why because we want to know how much what is our cost what is our cost of debt how much it's costing us to raise money and what is our cost of equity how much it's costing us to raise equity remember equity you have to pay dividend there's a preferred stock cost so on and so forth. So what's the cost and what's the cost of the debt and what's the cost of equity given the fair market value of debt and equity and how do you find out the fair market value of the debt we take the number of bonds times the market value of the debt the stocks the number of shares times the times the market market price of the stock now we don't care about the short term that because the short term that is is basically valued at book value so we don't worry about the short term that so what we left with is long term that which is bonds usually bonds and loans and for equity retained earning is internally generated we don't have to worry about this we have to worry about the cost of common stock and preferred stock now how do we find the cost of equity and the cost of debt I'm going to simplify it let's assume we have $100 of assets of which 60 coming from debt and $40 coming from equity this is a simple example but this is going to help you once we get to the more advanced what do we say we say that the proportionate share of the assets that's coming from that is 60 percent so if we take 60 divided by 100 it's equal to 60 percent and 40 divided by 100 equal to 40 percent so 100 percent of assets 60 percent 60 percent of it coming from that 40 percent coming from equity let's take this simple step simple example further before we go into the actual lesson and if we look at if we assume that for the debt we have a cost of let's make it six percent yeah six percent it doesn't matter let's assume that the cost of that the cost of that is six percent so we're going to take 60 percent times six percent this is the cost of that and let's assume the cost of equity it's going to be cost of equity is a little bit more because the equity has more risk let's assume it's 10 10 percent that's the cost of equity let's go ahead and do the simplified computation without taking into account the tax deduction for the debt so give me one second here so if I take 0.6 times 0.06 my cost of that is 0.036 now this is going to be lower because eventually we're going to introduce the tax deduction of interest for the debt but that's we're not going to worry about this and now we're going to take 0.4 times 0.1 and the cost of equity is 0.04 so 0.04 plus 0.036 we find out that the cost of equity for this company is 0 wait 7.6 or 0.076 or 7.6 percent what does that mean what does this WAC mean it means the company will have to earn on their investments more than 7.6 percent again you're going to see later that this is the cost of debt is cheaper because we're going to we're not taken into account the tax deduction we're going to look at it in a moment but the point is I'm just giving you the overall picture the 7.6 is the cost of financing this is what we call the hurdle rate so if the company wants to take any project they have to earn more than 7.6 if they earn more than 7.6 the value of the firm should increase the value of the stock should increase if they undertake any investment where the return is less than 7.6 then they're going to be in trouble in a sense that it's costing them more money than the cost of money think about it if you go to the bank and you borrow money at 7.6 percent you want to invest this money at something greater than 7.6 percent otherwise you are at a loss because you cannot even cover your cost so that's the idea that's why the weighted average cost of capital is very important once again it's lower than 7.6 because the cost of interest we're going to see shortly that it's it's tax deductible in other words it's less because you get it you get a tax break on your interest let's go ahead and look at the book and see what they're telling us now we're going to be using you know fancy finance language okay suppose a firm uses both that and equity and mostly most firm uses that and equity to finance its investments if the firm pays rb for its debt so this is the cost of that rb the cost of that and rs for the cost of the equity we don't know what they are now but this is going to be the percentage and the percentage of equity what is the overall uh what's the overall or average cost of capital well the cost of rs as discussed in earlier section we talked about this the cost of that of the firm borrowing is rb which we often observe by looking at the yield to maturity on the firm's debt what is the let's let's let's what's the cost of that simply put if you borrow a thousand dollar and if you're paying 10 a hundred dollar in interest your cost of that is 10 percent so basically you'll take how much you are paying to to finance your to finance your debt divided by the the the amount of the loan so you could have you could have 15 different loans at the end of the day just tell me add up all your interest for the year all your interest for the year for those 15 loans is 15 thousand dollar that's fine tell me what's the how much debt do you have in total i have 250 000 well now i can find out what is your cost of that how because if you paid 15 000 dollar in interest and you have 250 000 in loans outstanding let me tell you your cost of that is six percent so this is how we find our subscript b which is your cost of that so what we do is this we find the proportion of stocks remember what we said this is how much stocks you have divided by stocks plus bonds so this is the total so this is think of this what i showed you in the formula because in finance books they make it sound fairly like complicated what this is this is the assets how much assets you have in total and here we're taking the stocks how much stocks do you have relative to your total assets and how much bonds or that you have relative to your total assets because debt plus equity equal to assets so this is the total this is the total value then you multiply this percentage by your cost which is by the percentage and you multiply this by the percentage okay the weights and the formula are respectively the proportion of the total value represented by how much stocks you have divided by stocks and bonds and how much bonds you have divided by stocks and bonds now for some companies if they rely more on for example some companies they might have capital structure of 70 percent and equity and 30 percent bonds it means they rely more on equity than bonds in some companies it's the opposite for example they will have 70 percent bond and 30 percent equity where the proportion could be 50 50 what is the optimal proportion it depends on your company it depends on your industry depends on the interest rate throughout the year if you if the interest rate is low let's think about it nowadays for example in the u.s the interest rate is low most companies maybe they really i'm not saying most companies but they're more likely to rely on that it doesn't mean this is the proportion these days but what i'm saying is you are more likely to rely on that why because the cost of that is very is very low therefore you would finance yourself with that okay and that's why we could have a bubble down the road bond bubble because companies are financing themselves through that but that's beside the point so this is what we are saying here now we're going to introduce the tax deductibility of that that because the interest that you pay on the debt is tax deductible so what happened is when you finance your company with that your cost it's going to be lower why okay so interest is tax deductible it means you can deduct it on your taxes you you have a tax savings at the corporate level the after tax cost effect of that so when you compute your cost of debt it is it is the cost of debt times one minus the tax rate now the tax rate in the u.s now is 21 percent so let's go back to that example and show you how we apply this formula if i say the cost of that the cost the cost of that here was six percent i told you it's going to be lower than six percent why lower than six percent we're going to take six percent and multiply it one minus the tax rate again the tax rate in the u.s is 21 percent so what's going to happen is this so i'm going to take 1 1 minus 0.21 it's a 0.79 times 0.06 so you're true color okay okay daddy i'm going to choose the green yeah okay so what's going to happen my son wanted me to choose a different color sorry about that so the cost of the cost of equity is 0.0474 as i told you it's lower is 4.74 percent so notice again now we're going to take 4.74 plus i'm sorry times sorry now this is 4.74 0.0 let me just look at it one more time 4.74 4.74 i'm going to multiply this by 60 to find the true cost of capital the cost of that times 0.6 oops times 0.6 0.0474 times 0.6 60 percent is financed in that so notice my cost of that is 2.844 2.844 percent so now it's 2.844 plus 0.04 as i told you it's 6.844 as i told you earlier that my cost of capital for this company is lower than 7.6 it's even 6.844 why because i was able to take an advantage of my interest my interest the six percent that i pay it's not really six percent it's 4.74 why because i have a tax deduction of 21 percent i have a tax deduction of 21 percent and we're going to work another example but remember that the cost of that you will take the proportion whatever you find out i'm sorry you'll take the rate let's find the rate then you multiply it one minus the tax rate in the u.s now the tax rate is 21 percent therefore it's going to be lower so if they told you the cost of that is six percent or the cost of that is four percent well it's going to be lower once you multiply it by one minus the tax rate now the best way to illustrate this as i said is to work an example um so let's take a look at this example to illustrate the concept and hopefully it will make sense how to compute this consider a firm whose that has a market value of 40 million and whose thoughts is a fair market value of 60 million simply very very simply put very similar to the capital structure that i had earlier so the firm has 100 million in total a 40 million in debt and 60 million in equity now this is easy this is that and this is equity well that represent 40 percent equity represents 60 percent this is the weight the firm pays five percent of interest on the new debt and has a beta of 1.41 well i can immediately figure out the debt the debt is 40 percent they pay five percent on it but remember they pay five percent but the tax rate is 21 percent so simply put the after tax rate let me find out the after tax rate for the debt if we take five percent times 0.79 which is one minus 0.21 it's the the after tax rate is three point let me keep this open 3.95 so this is my this is my my the cost of debt they told me it's five percent they told me it's five percent but it's less than five percent because what i'm going to do i'm going to take the five percent multiplied by 0.79 this is the after tax rate i hope you understand what the after tax rate is otherwise go to my intermediate accounting and i will show you what after tax rate is a little bit more indeed so we find out your cost of debt now let's find the cost of equity well here's what we are told we are told sometime the cost of equity is giving sometime they tell you in a problem the cost of equity is let's assume sometime they tell you it's like eight percent or sometime what they do they don't give you eight percent what they do is they gave you a bunch of a bunch of information like they're telling you the beta is 1.41 if you don't know what the beta go back and view the beta the beta is 1.41 the corporate rate they're giving us assume the security line holds at a risk premium is 9.5 and the current treasury bill is one one percent so here's what we are giving enough information to find the cost of to find the cost of equity we are giving beta we need beta we need the tax free rate sorry the risk free rate return which is the treasury bill is one percent and we're giving the premium now to find the cost of to find the cost of equity which is the cost of the 60 percent we're going to take the risk free rate which is one percent plus the risk premium the beta which is 1.41 times the risk premium and already telling us the risk premium is 9.5 which is rm rm really is 10.5 minus 1 percent which is which is 9.5 but kind of they did the computation all at once so simply put if we take 0.01 we would take this formula and we solve it we find out that the cost of equity is 14.4 now we have everything so we have 60 percent first we already completed this completed this this is 40 percent times 0.395 this is the cost of that and the cost of equity is 60 percent times 0.1440 which is 10.22 percent so the cost of capital for this company is 10.22 percent which is what which is is it high is it low i don't know but it's 10.22 so if you want to undertake any project you want to make sure you earn greater than 10.22 percent and this is the computation again showing showing it to you in a different way 40 million times 4 percent times the rate but remember the cost of that you'll have to make the adjustment you will take the cost of the debt times one minus the tax rate and it's now 21 percent in the us so the through the true cost of 3.95 the cost of equity is 60 million times 60 percent which is which will give you the cost of equity we computed as 14.4 8.64 together 10.22 so hopefully this will help you to compute the weighted average cost of capital once again if you don't understand how the after after that cost you know work please look at my intermediate accounting specifically discontinued operation i explained this concept much much more in details as always i would like to remind you to visit my website for additional resources especially if you're studying for your cpa or cma exam or if you are taking a corporate finance course good luck study hard and stay safe especially during those coronavirus