Learn Financial Modeling: Discounted Cash Flow statement (DCF) Methodology
4. Calculate the Weighted Average Cost of Capital
Before we begin, I want to discuss what WACC is and why we use it. WACC is the weighted average cost of capital. It is a blended rate of return for all the capital providers of a company. Technically if a company had preferred stock you would include that in the WACC calculation. Many practitioners do not do this because preferred is not a common part of the capital structure. Even if it is present its value is generally small. None the less, from an academic standpoint you would want to include it.
You are probably saying well why are we using WACC as the discount rate for our cash flows. Remember, this is an unlevered free cash flow analysis which is before the payment of interest. Earnings before interest (EBI) is before interest expense payment. These cash flows are available to all providers of capital, not just the equity investors. Had we used a levered free cash flow approach the appropriate discount rate would have been cost of equity only. WACC accounts for all the capital providers. To make an apples-to-apples analysis we use WACC to discount the cash flows back to the present. Now that we understand why we use WACC let us start tackling this section.
The first thing we are going to do is reference the share price. Followed by the beta value for the stock. Beta will be used when we calculate the cost of equity.
Next is the diluted share count which gives us the number of shares that are outstanding. What do we mean by diluted shares outstanding? A company has a basic share account and that is what you typically get from the front page of a listing. Diluted shares outstanding considers all the claims of ownership. These claims arise from options warrants, convertible debt or convertible preferred that are in the money. We want to account for all the different ownership claims and that is why we are using the diluted share count. This value is obtained from the income statement.
Next in our list is cost of debt and then we have the tax rate followed by after tax cost of debt. You are probably wondering why we are using the after-tax cost of debt. Let us look at our free cash flow build up. As mentioned before this is an unlevered free cash flow approach which is before the payment of interest expense. We know something special about debt and that is interest expense provides a real tax shield to companies who pay taxes. Interest expense reduces taxable income and in some cases this reduction can be a substantial amount. Since we are doing an unlevered free cash flow analysis some might think that we are ignoring the effect of the interest tax shield, but in fact we are accounting for it in our WACC calculation. That is why we are using the after-tax cost of debt.
After-tax cost of debt represents the interest tax shield that the company benefits from by using debt in their capital structure. To calculate after-tax cost of debt we take the cost of debt times 1 minus the tax rate. You can see that this can significantly lower the actual debt cost. Cost of debt is not a very highly debatable topic. If you are dealing with a company, you usually use yield to worst and if you are using comparable company debt you usually use yield to maturity. Practitioners as well as academics do not really butt heads on this calculation.
Cost of equity on the other hand is a highly debatable topic. Business school professors versus practitioners tend to disagree on what the cost of equity should be. It is highly debatable compared to cost of debt. With cost of debt you know what you are getting (principle plus interest expense). With cost of equity you really do not know as it is a combination of potential dividend payments and price appreciation. Some of the competing cost of equity models are Fama-French, dividend discount model, as well as capital asset pricing model. We are going to focus on what practitioners use which is the capital asset pricing model. That model is equal to the risk-free rate plus beta times market risk premium.
By the way, the market risk premium is very subjective and varies a lot. To make it consistent we use the Risk Premium Arithmetic Average for the period 1928-2016 which is 7.96%.
Debt holders require that we know what costs are for both debt and equity. Let us figure out what our capital structure will be. Debt and equity costs are an important point that you want to include in your WACC calculation. We use a target capital structure as used by most mature companies. We want to use market values for both debt and equity, but many times you do not have market values for debt. What we use is total debt from the latest balance sheet given that book value is a good proxy for market value. To summarize, an acceptable proxy for debt market value is debt book value. Equity is going to be share price times the diluted share count. This value is commonly referred to as market capitalization.
Debt weighting is going to be total debt divided by total capital while equity weighting is equity divided by total capital. You can see that this adds up to one hundred percent. If there were preferred stock you would figure out the amount of preferred that is in the capital structure and apply a weighting there as well. Now that we have our debt and equity weightings, we can calculate WACC. Again, WACC is a blended rate of return. To obtain WACC multiply equity weighting times cost of equity plus debt weighting multiplied by cost of equity. With this value in place our cash flows can update with the appropriate present values. Another assumption is that WACC does not change in the terminal value period. This allows our stage two to be updated to the correct present value. Now that we have calculated WACC and brought that into the model we can calculate enterprise value which is the combination of stage 1 and stage 2 present values. Our next step is equity value.