Weighted Average Cost of Capital (WACC)

WACC/Discount Rate:

• For investors: discount rate is the expected rate of return of investing in a company. It represents the opportunity cost of what they could earn by investing in other similar companies in the industry
• Higher discount rate = higher risk = higher returns
• Smaller companies tend to have higher discount rate than larger ones
• For companies: discount rate is the cost of capital
• To calculate discount rate, we separate capital structure into components of equity, debt, and preferred stock, and calculate the cost of each one

• WACC: weighted average cost of capital
• WACC is used as the discount rate in a DCF to calculate the present value of a company's cash flows and the terminal value
• It reflects the overall cost of a company's raising new capital, which is also a representation of the riskiness of investing in the company

WACC = (equity * cost of equity) + (preferred stock * cost of preferred stock) + (debt * cost of debt * (1-tax))

• Essentially a calculation of a firm's cost of capital in which each category of capital is proportionally weighted

Cost of Equity: 

We calculate cost of equity because equity can cost the company in 2 ways:

1. Dividends issued to common shareholders
2. By issuing Equity to other parties, the company is giving up future stock price appreciation to someone else

Calculation:

Cost of Equity = risk-free rate + levered beta * market risk premium 

• Risk-free rate: interested rate earned by investing in a riskless security, such as a 20 or 10 year US treasury note
• Market Risk Premium: extra yield you earn by investing in an index that tracks the stock market
• Beta: measurement of volatility, represents riskiness of the company relative to all other companies in the stock market
• Beta = 1: company is just as risky as market
• Beta > 1: company is riskier than market
• Beta < 1: company is less risky than market
• You could use a company's historical beta, but you could also make your own beta by using a comps for the company you're valuing.
• Calculating Beta:
1. Find the Beta for each of the companies in your public comps 
2. Unlever the Beta for each company using the formula
• Unlevered Beta = Levered Beta / (1 + (1 – Tax Rate) * (Debt / Equity Value))
• Q: Why do we unlever Beta? 
• A: Beta encompasses two types of risk: the inherent business risk and the risk from debt. Levered beta reflects the debt already assumed by each company. But each company's capital structure is different and we want to look at how risky a company is regardless of what % debt or equity it has. To get that, we need to unlever Beta each time. But at the end of the calculation, we need to relever it because we want the Beta used in the Cost of Equity calculation to reflect the true risk of our company, taking into account its capital structure this time. 
3. Take the industry median, then re-lever it to calculate the Levered Beta for our company
• Levered Beta = Unlevered Beta * (1+(1-tax rate) * (debt / equity value))
4. Calculate cost of equity using the re-levered Beta

Cost of Debt:

• Cost of Debt = interest rate on debt
• Cost of Debt is usually calculated via 2 ways:
1. Averaging the yield to maturity for a company’s outstanding debt, i.e. how much interest return someone can expect to earn from investing in a particular debt instrument until it matures (reaches the end of its term).
2. Cost of Debt = risk-free rate + spread 
• Look at the company’s credit rating from firms such as Moody’s and S&P and then add a relevant spread over risk-free assets (for example, Treasury notes of the same maturity) to approximate the return that investors would demand
  
• Note: we multiply (1 - tax rate) to the cost of debt to account for the tax deductibility of interest expenses. Interest payments on debt are tax-deductible expenses for businesses, i.e. company ultimately pays less in taxes. This is why debt will always cost a company less than equity or preferred stock

Cost of Preferred Stock:

• Cost of preferred stock = preferred dividend / principle value of preferred stock
• Principal value: refers to the face value or the initial investment amount of the preferred shares
•  This represents the amount of money paid to preferred shareholders as dividends
• Normally companies don’t have preferred stock - which is why a lot of people just omit this section. But if they do you should include it

Note:

• If we're using unlevered free cash flow, we use WACC as the discount rate because we care about all parts of the company's capital structure, and we will get the enterprise value
• If we're using levered free cash flow, we use cost of equity as the discount rate because we only care about equity investors, and we're calculating equity value rather than enterprise value