WACC, Cost of Equity, and Cost of Debt in a DCF
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- Опубліковано 22 вер 2014
- Learn more: breakingintowallstreet.com/co...
In this WACC and Cost of Equity tutorial, you'll learn how changes to assumptions in a DCF impact variables like the Cost of Equity, Cost of Debt.
By breakingintowallstreet.com/ "Financial Modeling Training And Career Resources For Aspiring Investment Bankers"
You'll also learn about WACC (Weighted Average Cost of Capital) - and why it is not always so straightforward to answer these questions in interviews.
Table of Contents:
2:22 Why Everything is Interrelated
4:22 Summary of Factors That Impact a DCF
6:37 Changes to Debt Percentages in the Capital Structure
11:38 The Risk-Free Rate, Equity Risk Premium, and Beta
12:49 The Tax Rate
14:55 Recap and Summary
Why Do WACC, the Cost of Equity, and the Cost of Debt Matter?
This is a VERY common interview question:
"If a company goes from 10% debt to 30% debt, does its WACC increase or decrease?"
"What if the Risk-Free Rate changes? How is everything else impacted?"
"What if the company is bigger / smaller?"
Plus, you need to use these concepts on the job all the time when valuing companies… these "costs" represent your
opportunity cost from investing in a specific company, and you use them to evaluate that company's cash flows and determine
how much the company is worth to you.
EX: If you can get a 10% yield by investing in other, similar companies in this market, you'd evaluate this company's cash flows against that 10% "discount rate"…
…and if this company's debt, tax rate, or overall size changes, you better know how the discount rate also changes! It could easily change the company's value to you, the investor.
The Most Important Concept…
Everything is interrelated - in other words, more debt will impact BOTH the equity AND the debt investors!
Why?
Because additional leverage makes the company riskier for everyone involved. The chance of bankruptcy is higher, so the "cost" even to the equity investors increases.
AND: Other variables like the Risk-Free Rate will end up impacting everything, including Cost of Equity and Cost of Debt, because both of them are tied to overall interest rates on "safe" government bonds.
Tricky: Some changes only make an impact when a company actually has debt (changes to the tax rate), and you can't always predict how the value derived from a DCF will change in response to this.
Changes to the DCF Analysis and the Impact on Cost of Equity, Cost of Debt, WACC, and Implied Value:
Smaller Company:
Cost of Debt, Equity, and WACC are all higher.
Bigger Company:
Cost of Debt, Equity, and WACC are all lower.
* Assuming the same capital structure percentages - if the capital structure is NOT the same, this could go either way.
Emerging Market:
Cost of Debt, Equity, and WACC are all higher.
No Debt to Some Debt:
Cost of Equity and Cost of Debt are higher. WACC is lower at first, but eventually higher.
Some Debt to No Debt:
Cost of Equity and Cost of Debt are lower. It's impossible to say how WACC changes because it depends on where you are in the "U-shaped curve" - if you're above the debt % that minimizes WACC, WACC will decrease.
Otherwise, if you're at that minimum or below it, WACC will increase.
Higher Risk-Free Rate:
Cost of Equity, Debt, and WACC are all higher; they're all lower with a lower Risk-Free Rate.
Higher Equity Risk Premium and Higher Beta:
Cost of Equity is higher, and so is WACC; Cost of Debt doesn't change in a predictable way in response to these.
When these are lower, Cost of Equity and WACC are both lower.
Higher Tax Rate:
Cost of Equity, Debt, and WACC are all lower; they're higher when the tax rate is lower.
** Assumes the company has debt - if it does not, taxes don't make an impact because there is no tax benefit to interest paid on debt.
![Working Capital and the Change in Working Capital in Valuation and Financial Modeling [REVISED]](http://i.ytimg.com/vi/tMgty8jwmHI/mqdefault.jpg)
Thank you for the video! This is my first time taking a Mergers and Acquisitions class in my program, and this is so helpful in helping me understand the materials.
Thanks for watching!
Perfect. You made me understand a lot as a student. This is really nice.
Thanks for watching!
Brian, you're the big guy! I can't tell you how much of a help you have been to me!!
Thanks for watching!
just want to say thank you for the all the video resources. It helps tremendously and I appreciate it ton!
Thanks for watching!
Good, I learnt so much by this.
best video on this topic... thank u very much... I was little confused first.. but now my concept is clear.......
Thanks for watching!
Very useful input! Thank you very much.
Yifei: Yes, we could not mention it due to time constraints (it would have made the video even longer than it already is). But Preferred Stock is more expensive than debt and Preferred Dividends are not tax-deductible. Generally, the other changes that apply to debt also apply to Preferred Stock (higher Risk-Free Rate = higher cost of Preferred Stock, for example) except that taxes have no impact since Preferred Dividends are not tax-deductible. It's harder to predict what will happen when going from some Preferred to no Preferred or vice versa because sometimes it is more expensive than Equity and sometimes it is less expensive than Equity. But it generally reduces WACC less than Debt, even if it is cheaper than Equity, because it's still more expensive than Debt.
Great video, thanks for sharing your knowledge
Thanks for watching!
top notch, the best IB training course on the market
Thanks for watching!
Very useful, thanks !
Thanks for watching!
Thx for the video !
+Károly Holczhauser Thanks for watching!
Thanks, very helpfull!
Thanks for watching!
Hi Brian, keep up the good work we learn so much from you
I wanted to ask if you can please explain how to deal with taxes in valuation. First of all which tax rate should we use when projecting the financial statements ( the statutory vs effective vs cash tax rate). Also, what should we do about deffered tax assets/liabilities sitting on the balance sheet. Please share in detail if and how we should project their balances and if not should we make adjustments of these tax assets/liabilities to Enterprise value to reach the equity value like we do for cash/ investments
Thanks
You should use the effective tax rate but adjust for deferred taxes in the DCF by making an adjustment to FCF (the adjustment can be either negative or positive). So, effectively you are getting to the cash tax rate. Please see the video on NOLs in a DCF for your other question.
Thank you so much!! It really helped me a lot in understanding the three costs in a DCF model. But I'm still confused that for higher taxes, why is the implied value from the DCF dependent on other factors (like what factors) and why is it usually lower?
Higher taxes make Debt cheaper because Interest Rate * (1 - Tax Rate) is lower at a higher tax rate, but higher taxes also reduce the company's FCF. So it depends a bit on the specific numbers. But in general, the higher tax rate makes more of an impact on the company's FCFs, which will reduce its implied value in a DCF.
Amazing video. Short two questions about the WACC: (1) Leveraged Beta - How do we calculate Leveraged beta for each of the comparable company’s in the WACC analysis? Are we using regression that checks the market index and the company’s stock price for a specific period of time? (2) Discount Rate - Is there a way we could derive a company’s discount rate, based only on the stock’s price and without knowing the entire cash flow projection? Thanks a lot in advance anyway.
1) You can look up Levered Beta on Bloomberg, Capital IQ, even Google Finance, Yahoo Finance, Finviz, etc. These numbers are usually based on regressions over a few years.
2) You might be able to determine the Cost of Equity knowing just the stock price since an alternate calculation for it is Net Income / Equity Value, but you can't determine the Cost of Debt or Preferred just from the stock price, so no, in most cases probably not.
Thanks for your helpful videos! They really made me better understand the DCF topic. Just one question: If I understood that correctly, you say that debt cost [without multiplying by (1-tax rate)] are affected by changes in tax rate. Could you maybe explain why that is the case?
+Bastian Normalverbraucher No. The pre-tax cost of debt is not affected by the tax rate. Only the after-tax cost of debt is.
Hi, thanks for the video!
Could you tell us how exactly the tax rate affect the levered beta (hence cost of equity)? Could you detail the formula of beta that include the tax rate?
A higher tax rate reduces the Cost of Debt because it increases the tax benefits of Debt.
But a higher tax rate will also reduce the Cost of Equity because you use that tax rate when re-levering Beta: Re-Levered Beta = Unlevered Beta * (1 + Debt / Equity Ratio * (1 - Tax Rate)).
A higher tax rate enhances the cost benefits of Debt, which means that additional Debt is also less risky for the Equity investors.
So, WACC decreases with a higher tax rate, assuming the company has Debt.
Thank you.
Thanks for watching!
In calculating WACC weighting’s for equity do use net assets or market cap.
Market Cap. You should use the Market Value of each item in the WACC calculation (definitely for Equity, but also for Debt and Preferred Stock where available).
Thank you for the explanation, quite helpful. Can you please help I don't understand the impact of Non-Controlling Interest (minority interest) under the equity section if we want to calculate the WACC of a group. If you could make a video on that I would b very happy... thank you🤗
You don't factor Noncontrolling Interests into the WACC calculation. If you had to calculate WACC for a group, it would be better to look at each subsidiary separately and take some kind of weighted average.
Thankyou its a very clear and deep explanation from you, but can you tell us the concept and application of adjusted present value for modeling? I just face difficulties when trying to learn. See for your next upload, regards
We cover this concept in our Interview Guide and elsewhere on the site. We don't think Adjusted Present Value is a useful or particularly valid analysis (and Damodaran agrees).
Thanks for the good job! Actually I wanted to point out that risk free rate changes affect Ke differently according to Beta Value! If B > 1, an increase of risk free should decrease Ke and viceversa
??? Not sure what you mean, we cover the impact of the Risk-Free Rate in the table. It is true that the real-life changes may not match the ones shown here, but strictly in terms of the formula, a higher Risk-Free Rate means a higher Cost of Equity.
The risk-premium in the formula for cost of equity is also affected by the change in risk-free rate. So if you deviate cost of equity for risk-free rate, you get 1-beta(equity). Therefore, for beta > 1, increase of risk-free decreases cost of equity.
Hello,
First of all thank so much for making such videos for students like us who are in need to find such study materials so thank you for creating such youtube channel !! :)
Secondly, I wanted to request you to please look over your mic or its configuration because some times it really hurts in the ear. There are many times in a video the sound strikes in the ear. I have tried to use different earphones and airpods and yeah i hear the same thing in the other videos too. I am not sure but i think that it is the air(breath) which comes out while you speak and both the voice and the air makes a different sound together.
So i would request you to please check it !!!
Again thank for your videos !! :)
So, a lot of these videos are older and have since been replaced by newer versions in our courses with better audio/video quality. This channel has over 100 free samples, and I make exactly $0 from the videos posted here, so I don't have a high incentive to recreate everything just to fix audio problems in old lessons from almost a decade ago. We occasionally replace and update the tutorials here, but it's not high on the priority list.
Thanks for the great videos. Do you have videos for networking in LinkedIn?
There is some coverage of LinkedIn in the Networking Toolkit we offer.
Thank you for the explanation. Would like to know if you provide the excel resource?
For this one, no, but there are similar files throughout this channel.
Hi Brian, thanks for the video! What is the difference between optimal and targeted capital structure? I understand that it is difficult to use a targeted capital structure in a DCF because you usually don't have information about a company's future capital structure, but why would we ever use an optimal capital structure (one that minimizes WACC)? If the company isn't minimizing WACC, what's the purpose of it?
There isn't much of a difference in real life. People say that optimal capital structure "minimizes" WACC, but there is no way to estimate it because it's a single equation with multiple variables. So in practice, both these terms usually just mean "use the median capital structure percentages from the comparable companies."
Hi, Brian.
Thanks for another great video.
May I ask a quick one?
If I have model a company with a non-constant capital structure, what WACC should I use to discount the cash flow? The current WACC as fixed or use the WACC for each period?
Many thanks!
Stat with the company's current WACC and make it change to the long-term WACC over time and use cumulative discount factors to calculate the PV of cash flow in each period.
@@financialmodeling Thanks for the swift reply! Have a great week!
This is great... Is the spreadsheet available? I want to understand the mechanics better.
This one is not available, but there are similar DCF/WACC spreadsheets in this channel.
Hi, thanks for video, i have one question about tax shield, don't we count it twice, the first time when we count cost of debt * (1-t) and the second time when we count beta D / E * (1-t)?
No, because the tax shield affects both the cost of debt and the company's overall risk and potential returns. Beta and the Cost of Debt measure different things.
how would you go about to predicting WACC in a DCF for the future discount rate? or do you usually use the same WACC as the discount rate throughout all the cash flows and terminal value
Look at the company's own disclosed plans or look at the discount rate for older, more established companies in the sector and assume that your company will eventually reach that point. You sometimes assume a changing discount rate, but it is more common for smaller, high-growth companies, and less common to do that for large, established companies that aren't changing much.
thanks a lot for the reply. Would you also have to factor into the Fed discount rate as that will impact cost of equity, thus WACC, or is that negligible? obviously this is assuming the company is continuously changing its capital structure
You're over-thinking it, just go with the current rates the company is paying and base the capital structure on comparable companies in the absence of other information.
Thank you so much! Do you have the excel file for this video?
Thanks! This one is part of a much larger model, so it would not make much sense on its own unfortunately (the inputs come from various places throughout a big Excel file). We do have the file within our Fundamentals course in the lessons there.
Hi!
Thanks a lot for the video, but i have one more question on calculating of the levered beta. What exactly capital structure (D/E) should we use to calculate levered beta? As i understand we have two options: (1) target capital structure of a particular firm or (2) industry average capital structure in order to get CAPM for the industry and than adjust it (i.e. size premiums, CRP, etc.) to get CAPM for a particular firm?
Thanks in advance!
Alexander Mylnikov Opinions vary on that one, but if you are asking about re-levering Beta for a company, technically you should use the company's targeted capital structure. But in practice, that "targeted" or "optimal" capital structure is really just the industry median capital structure for similar companies because companies rarely disclose their capital structure plans. So you'll often end up using the industry average capital structure even if you want to use the targeted capital structure.
The beta of companies which is published on various stock information platforms like yahoo finance & Google finance etc. , is it levered or unlevered?
Secondly, if I calculate beta of the stock on my own using covariance , variance of stock & market returns , will that beta be levered or unlevered?
Levered. If you make no adjustments and just use stock and index prices, Beta will be Levered.
How do I usually know which market I should use for the Equity risk premium? The S&P wouldn’t be useful for a company operating in Europe right ?
You can find the ERP data for other markets/regions by searching online (see Damodaran's data). Or just use the U.S. data and add a premium for the market you're in.
12:36 could you tell me what you said here? That's what I got:
The impact on cost of debt (N/A) is vast predictable for equity risk premium and beta because they are not quite exclusively prevailing interest rates of the economy so this is N/A but you could see a different purchase as well? "purchase"?
"The impact on Cost of Debt is less predictable for the Equity Risk Premium and Beta because they're not quite as closely linked to the prevailing interest rates in the economy, so I've listed these as "N/A", but you could see different approaches here as well."
@@financialmodeling thanks a lot :)
Is this MM Proposition II? Taking on debt will have benefits up to an optimal level?
+Mike Lim Yes, but unlike MM Proposition II we are factoring in taxes, agency costs, and the risk of bankruptcy here.
Hi Brian, Thanks again for these amazing Videos.
I am wondering if a company is under Income Tax Holiday for 10 years (the effective tax rate will be 0%) while after 10 years, the company have to pay 25% tax on pretax income. In this case, shall I apply 0% tax rate to the WACC formula and discount the cash flow for the first 10 years, and 25% tax rate apply to WACC when discounting Terminal Value?
Should I always use effective tax rate in formula of WACC or the stated income tax rate from tax law?
You should use the company's long-term tax rate of 25% in the WACC formula. For cash flow projections, use the lower rate at first, but make sure it eventually moves to 25% in or before the terminal period.
@@financialmodeling Thank you!!
Would a change in the interest rates on your debt affect both the cost of equity and debt? Thanks
Potentially, yes, but it depends on why the interest rates on Debt have changed (e.g., the risk-free rate has changed vs. the company's credit risk has changed).
on an exam i was given numbers such as $100million borrowed investment from shareholders then had to work out their percentage rate of return (12%) and then when it came to multiplying these numbers, you can imagine what the figures were... have you got examples containing high numbers such as $100million etc?
I have no idea what you are asking. We have plenty of examples of WACC and Cost of Equity calculations. I'm not sure why using $100 million makes the calculation more difficult (???????).
fan
how does a DCF model change over time? do you change the year cash flows?
??? It depends on the company, the industry, etc., but generally you want the FCF growth rate to greatly decrease over time and approach something less than the rate of GDP growth as you get to the end of the explicit forecast period. Usually that involves forecasting lower and lower revenue growth and stabilizing margins over time.
Sorry if i worded the question weirdly. I am saying if one holds makes an investment and over a year you get financials of that company, will you use those numbers as a base year or would you project out year 2 and year 3 without changing the cash flow that the company has already received over the year? I hope that clarifies the question!
You will change your projections based on how the company is performing. If one year of results gets reported, that becomes a historical year and is no longer in your forecast. As results get reported, you will then adjust the projected years up or down as appropriate (and extend the forecast each year for each year of results reported).
How much should UK non finance students know around valuations and accounting for internship interviews?
You should be well-prepared for the types of questions covered in these videos. Technical standards in interviews have increased significantly.
thanks a lot sir...
i really appreciate u make this video
but i wanna ask you, i still don't understand why cost of equity is higher than cost of debt (percentage of cost of equity is higher than cost of debt),
i think cost of debt is more expensive than cost of equity because my lecture n some literature said financing from equity is cheaper than financing from debt. so leverage (DER) have a negative relationship on profitability...
can you explain it to me?
thank you...
No. Equity has higher potential returns but also higher risk than Debt (because there's a much greater chance of losing money), so the Cost of Equity is higher. Plus, interest on Debt is tax-deductible, further reducing the Cost of Debt. Would an investor expect to earn more by investing in the stock market over the long term or by investing in corporate bonds? Look at the historical data over the past 100 years, and that answers the question.
thanks for your explanation
Can someone explain what the "risk spread" represents?
The additional risk above and beyond the risk-free rate (typically the 10-year government bond yield). This additional risk is because the company could go bankrupt, stop operating, default on its payments, or otherwise stop being a worthy borrower.
Greetings ! Why cost of equity would go up when the ratio of total debt to capital go up? please explain one more time. Cost of Equity according to CAPM depends on the market risk premium. Why the premium will change due to the increase in debt to total capital? Higher debt will begin to impact EPS ( Earnings Per Share) when the organization is not able to utilize borrowings to earn higher profits. This in turn will raise market risk premium. Barring this possibility, cost of equity would continue to remain independent of debt to total capital ratio. Am I right? Thanks
More debt means more risk for all investors, including both equity (shareholders) and debt (lenders). It has nothing to do with EPS. Put simply, more debt means a higher chance of bankruptcy or default, both of which hurt all investors in the company and therefore increase their risk.
How do you know that when debt/Total capital is 10% then equity/debt = 11,1 and so on? I also wonder how you calculated the risk spread?(is it the same as credit spread and how to calculate it with more debt?)
I see how the risk spread is calculated, but why is the cost of debt 3,6% when there is no debt?
Basic math... If Debt / Total Capital = 10%, then Debt is 10% and Equity is 90% of the company's capital structure. 10% / 90% = 11.1%. Risk spreads are simple estimates based on data for companies with capital structures in those ranges.
Because even if the company has no Debt now, it would cost them something to issue new Debt in the future. And Cost of Debt is based on the likely interest rate on a hypothetical new issuance of Debt.
thankyou very much
Where can I finde Risk spread? I nead to do calculations on KPN and how do you know it goes from 1.0% to 1.5 and so on?
How do you calculate Beta for small & medium companies ?
It's the same process... find comparable companies, un-lever Beta for them, take the median, re-lever based on the company's current or targeted capital structure.
Hi there, I was calculating WACC and got a negative figure, intuitively this doesnt seem right. The reason for the negative figure was because there was a net loss for the period. So Re and Rd were both negative figures. This was an oil exploration company. what should I do in this circumstance were there's a net loss for the period?
Thanks in advance.
How/why would a Net Loss cause anything in the formula to turn negative? Cost of Equity is based on Beta and the company's capital structure and tax rate... and none of those could be negative (OK, technically Beta could be negative, but not for a company like that). I really don't understand how Cost of Debt could turn negative because that is based on the interest rate on debt. A negative Cost of Debt means that the company borrows money and then receives interest from the lenders it borrowed from, which doesn't make sense. I would take a look at your calculations again and change how you're calculating both of those because they should always be positive.
Mergers & Inquisitions / Breaking Into Wall Street
Your right, an error in my calculations. thanks very much!
+Mergers & Inquisitions / Breaking Into Wall Street
You may have a negative yielding bond, like Tesla, in such case the cost of debt is negative. How do you handle the negative yielding bonds in the estimation of cost of debt.
+Rajesh Kumar Mishra I don't know, actually. You may want to find some academic papers on the topic and see if anyone discusses it.
Can we get the Excel file presentation...?? Or How We can get it.??
+TopList Trends It's not available for this tutorial, but you can find similar files throughout the channel.
Is the excel sheet available?
For this one, no, but there are similar Excel examples in this channel. See any of the DCF coverage.
Is it bad if I still find these challenging, having done a non-quantitative degree?
Depends... maybe? It takes some time to learn these topics at first, but finance is not rocket science. You need some quantitative ability, but it's much easier than, say, engineering or physics. If you really don't like the ideas or work, then you may want to look at different roles that require more qualitative skills.
@@financialmodeling Just passed my interview because of your videos help! I think I'll just have to practice on excel more. It's certainly easier to speak about each step than to actually apply on excel, funnily enough.
Brilliant.. But it would be more better if u guys just define some short terms before using them. Like beta , risk free rate etc
The videos in this channel are not intended to be step-by-step tutorials. They are summary treatments of various topics, and some assume previous knowledge, and some do not. If we defined every single term or tried to summarize the entire written guide to this topic, it would probably be a ~5-hour video, so it just wasn't viable in this case.
What is the relevered beta formula?
=Unlevered Beta * (1 + Debt / Equity * (1 - Tax Rate) + Preferred Stock / Equity)
How can i download the excel spreadsheet ?
It is not available for this one. See the dozens or hundreds of other comment responses.
Can you provide excel template from video?
It's not available for this one, but you can find similar templates in the other videos in this channel.
@@financialmodeling Can you please tell me which video is?
Can we have the excel file uploaded please
+dradedman The Excel file for this one is not available because it's part of a much longer file that is hard to separate out.
Do you know Aswath Damodaran?
+Noah Leidinger No. But I know of him.
@@financialmodeling Definitely know him in 2022
you don't mention the preferred stock.
+yifei liu Yifei: Yes, we could not mention it due to time constraints (it would have made the video even longer than it already is). But Preferred Stock is more expensive than debt and Preferred Dividends are not tax-deductible. Generally, the other changes that apply to debt also apply to Preferred Stock (higher Risk-Free Rate = higher cost of Preferred Stock, for example) except that taxes have no impact since Preferred Dividends are not tax-deductible. It's harder to predict what will happen when going from some Preferred to no Preferred or vice versa because sometimes it is more expensive than Equity and sometimes it is less expensive than Equity. But it generally reduces WACC less than Debt, even if it is cheaper than Equity, because it's still more expensive than Debt.
Hello there,
May you elaborate on why, if all other things being equal, issuing Common Stock is more expensive for the company than issuing Preferred Stock? Intuitively, shouldn't the Preferred Stock issuance be more costly since it contains the characteristics of Common Stock (except for voting rights) + some debt characteristics like fixed dividend rate? Thank you.
No. Preferred Stock has a fixed coupon or dividend attached, and does not benefit from appreciation in the company's common stock (technically, some Preferred Stock can convert into Common Stock but that is more for early-stage startups with VC investments, not public companies). Most Preferred Stock is perpetual, or if it matures, the Preferred investors get back simply their principal and nothing more. Preferred Stock is therefore more like debt, except the dividends on it are not tax-deductible, making it more expensive than debt.
Thank you!