Dear propellor1,
You're right, the weighted average cost of capital (WACC) blends a
company's cost of debt and cost of equity into a single measure. It
takes into account the respective proportions of debt and equity in the
overall capital funding, hence the "weighted average" part.
The basic formula for WACC is the following.
WACC = E/V * R_e + D/V * R_d * (1 - T_c)
In this formula, E denotes the value of the firm's equity and D the
value firm's debt, while V is the sum E+D. So E/V and D/V are just
the proportions of equity and debt, respectively, in the sum of equity
and debt.
R_e is the cost of equity, and this is where the company's beta comes
in. As you may know, the beta expresses the degree to which a company's
stock is affected by movements in the overall stock market. A beta of 1
means that its stock moves in tandem with the market, a beta less than
1 means that it is more stable than the market, and a beta greater than
1 means that it is more volatile than the market. Here is the formula
for calculating the cost of equity, or rather for estimating it, since
this is an inexact science.
R_e = R_f + beta * (R_m - R_f)
The R_f here is the risk-free rate, or the rate of interest accruing to
essentially risk-free investments. A common measure used for R_f is the
interest rate on US Treasury bills. The R_m refers to the market rate,
which is the interest to be gained from investing in the stock market. The
number used for R_m is computed from historic stock-exchange data. The
difference R_m-R_f is called the equity market risk premium (EMRP),
since it represents the extra risk an investor takes on by investing in
stocks rather than something like T-bills.
Now let's return to the WACC formula, where we have two more symbols left
to explain. R_d is the cost of debt, meaning the average interest rate
that the company in question is paying on its debts. Because corporate
interest payments are tax-deductible, we should adjust the cost of debt
to reflect the degree of tax savings. That is the purpose of the final
symbol, T_c, denoting the corporate tax rate.
So in order to work out the WACC for a given company, you need to find
or estimate four measures specific to that company. You must know E,
the value of the firm's equity; D, the value of its debt; R_c, the
cost of its debt; and beta, its stock volatility. Then there are three
numbers to plug in that do not vary with the company. These are R_f,
the risk-free rate; R_m, the market rate; and T_c, the corporate tax rate.
All other values in the WACC formula follow from these numbers. Adding
E to D gives you V, and applying the second formula above lets you
compute R_e.
The chief difficulty you will have in calculating WACC for a given company
is finding out its E, D, R_c, and beta measures. The first three of these
can usually be found in the company's annual report. The beta is best
computed by sophisticated mathematical models, which is why subscription
services such as Barra and Bloomberg charge for their beta estimates.
If you find that any of the above is unclear or incorrect, please
advise me through a Clarification Request so that I have the
opportunity to fully meet your needs.
Regards,
leapinglizard |
Clarification of Answer by
leapinglizard-ga
on
12 Jun 2005 15:03 PDT
You can obtain the beta, total debt, and total equity figures for most
public companies from Yahoo! Finance.
Yahoo! Finance: Home
http://finance.yahoo.com/
You'll need a free Yahoo! account to log into this service. Once
you've done so, enter a company's ticker symbol at the top of the page
in the blue horizontal band. If you don't know the ticker symbol, use
the "Symbol Lookup" link to search for it based on the company name.
Once the summary page comes up, click on "Key Statistics" in the
column at left, under the "Company" heading. You should now be able to
find the beta under "Trading Information" and the total debt under
"Balance Sheet". There is also a figure marked "Total Debt/Equity" --
divide the total debt by this number to find the total equity. Now you
know the E, D, and beta measures for the company. The cost of debt,
R_d -- not R_c as I erroneously wrote in several places above -- is
not listed, nor can it be determined without an intimate knowledge of
the company's financing. You should assume that the company borrows at
market rates, and use the prevailing market rate as a reasonable
estimate for R_d.
The only more consistent source of technical company information would
be a paid service, the most popular of which is Bloomberg. Many
universities have Bloomberg terminals installed in their libraries.
You might like to check by calling your local universities' libraries
and business schools. If there is a Bloomberg terminal, a librarian
will most likely be available to help you use it. For instance, here
are instructions on finding betas with Bloomberg.
University of Washington: Finding Historical Beta on Bloomberg
http://www.lib.washington.edu/business/guides/beta.html
Bloomberg subscriptions are so expensive that only institutional
customers and the wealthiest individuals can afford them. That is why
Yahoo! Finance is such an attractive option, although I frankly don't
know just how broad its coverage is. You should try it out for some
companies you're interested in and see for yourself.
leapinglizard
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