WACC

A business is funded by two kinds of money and they cost different amounts. Lenders want a contractual rate. Shareholders want more, because they are paid last and can lose everything. WACC blends the two in the proportions the company actually uses.

It matters because it is the hurdle. A project earning less than WACC destroys value however profitable it looks on its own, and in a discounted cash flow it is the rate that converts future rupees into today's.

Two inputs, one weighting.

Cost of equity comes from the Capital Asset Pricing Model: the risk-free rate plus beta times the market risk premium. Beta is the firm's systematic risk and, as the workbook notes, reflects both business and financial risk.

Cost of debt is, in the workbook's words, "the prevailing interest rates in the economy for borrowers with comparable credit quality" — not the coupon on loans taken years ago. It is then multiplied by (1 − tax rate), because interest is deductible and the government pays part of it.

The weights are the proportions of equity and debt in the capital structure. Then the pairing rule, which the exam returns to: FCFF is discounted at WACC to give enterprise value; FCFE is discounted at the cost of equity to give equity value.

Ke = Rf + β × (Rm − Rf)                    ← CAPM, cost of equity

WACC = [ Ke × E ÷ (E + D) ] + [ Kd × (1 − t) × D ÷ (E + D) ]
     = Ke × We + Kd × (1 − t) × Wd

A pharmaceutical company: market value of equity Rs 6,000 crore, debt Rs 2,000 crore. Risk-free rate 7%, market risk premium 6%, beta 0.9. Cost of debt 9%, tax rate 25%.

Ke = 7 + 0.9 × 6 = 12.4%
Kd after tax = 9 × 0.75 = 6.75%
We = 6,000 ÷ 8,000 = 0.75      Wd = 0.25

WACC = 12.4 × 0.75 + 6.75 × 0.25 = 9.30 + 1.69 = 10.99%

Without the tax shield the blend would be 12.4 × 0.75 + 9 × 0.25 = 11.55%. The 56 basis point saving is the deductibility of interest, worth about Rs 45 crore of value on a Rs 8,000 crore capital base.

Now borrow more. The company swaps Rs 2,000 crore of equity for debt, so E = 4,000 and D = 4,000. Equity is now riskier, so beta rises to 1.25 and lenders want 10%:

Ke = 7 + 1.25 × 6 = 14.5%      Kd after tax = 10 × 0.75 = 7.5%
WACC = 14.5 × 0.50 + 7.5 × 0.50 = 11.00%

Twice the debt, and WACC did not fall. What was saved on the cheap leg was paid on the dear one.

What one point of WACC is worth: capitalise a free cash flow of Rs 305 crore growing at 4% — at 10.99% the firm is worth Rs 4,538 crore; at 11.99% it is worth Rs 3,970 crore. A 12.5% swing in the answer from a rate nobody can observe.

Chapter 10 (Valuation Principles, section 10.5) derives WACC immediately after CAPM and uses it as the discount rate in the FCFF model. Expect a direct computation from Ke, Kd, tax rate and the two weights, and a conceptual question on which discount rate goes with which cash flow — WACC with FCFF, cost of equity with FCFE.

• Weights use market values, not book values. The equity weight is market capitalisation, not share capital plus reserves.
• The (1 − t) applies only to debt. The cost of equity is already a post-tax return to the shareholder; there is no tax shield on dividends.
• Do not discount FCFE at WACC. FCFE is already net of interest and borrowings, so discounting it at a blended rate double-counts the debt.
• Cost of debt is today's rate for comparable credit quality, not the weighted average coupon on the existing loan book.
• More debt does not mechanically cut WACC. Beyond a point both Ke (through beta) and Kd rise, and the blend stops falling.
• Beta in the CAPM leg is the equity beta, which the workbook says already reflects both business and financial risk — so a leveraged firm's beta is not the same as its industry's.