306  Estimating the Cost of Capital Calculating the Weighted Average Cost of Capital In its simplest form, the weighted average cost of capital equals the weighted average of the after-tax cost of debt and cost of equity: WACC = − ( ) + D V k T E V k d m e 1 where D/V = target level of debt to value using market-based values  E/V = target level of equity to value using market-based values kd = cost of debt ke = cost of equity Tm = company’s marginal tax rate on income For companies with other securities, such as preferred stock, additional terms must be added to the cost of capital, representing each security’s expected rate of return and percentage of total enterprise value. The cost of capital does not in- clude expected returns of operating liabilities, such as accounts payable. Required compensation for capital provided by customers, suppliers, and employees is em- bedded in operating expenses, so it is already incorporated in free cash flow. The cost of equity is determined by estimating the expected return on the mar- ket portfolio, adjusted for the risk of the company being valued. In this book, we estimate risk by using the capital asset pricing model (CAPM). The CAPM adjusts for company-specific risk using beta, which measures how a company’s stock price responds to movements in the overall market. Stocks with high betas have expected returns that exceed the market return; the converse is true for low-beta stocks. Only beta risk is priced. Any remaining risk, which academics call idiosyn- cratic risk, can be diversified away by holding multiple securities, as explained in Chapter 4. In practice, measurements of individual company betas are highly imprecise. Therefore, use a set of peer company betas to estimate an industry beta. To approximate the after-tax cost of debt for an investment-grade firm, use the company’s after-tax yield to maturity on its long-term debt.1 For compa- nies whose debt trades infrequently or for nontraded debt, use the company’s debt rating to estimate the yield to maturity. Since free cash flow is measured without interest tax shields, use the after-tax cost of debt to incorporate the interest tax shield into the WACC. Finally, predict the target capital structure, and use the target levels to weight the after-tax cost of debt and cost of equity. For stable companies, the target capital structure is often approximated by the company’s current debt-to-value ratio, using market values of debt and equity. As we’ll explain later in this chapter, do not use book values. 1 The yield to maturity is not a good proxy for the cost of debt when a company has significant lever- age. We discuss alternative methods to estimate the cost of debt for highly leveraged companies later in this chapter. Calculating the Weighted Average Cost of Capital  307 For an example of the WACC calculation, see Exhibit 15.1, which presents the calculation for Costco. We estimate the company’s cost of equity at 8.5 percent using the CAPM. To estimate Costco’s pretax cost of debt, we add the default premium on Costco debt to a forecast of the risk-free rate, which leads to a cost of debt of 4.9 percent. In Chapter 11, we estimated Costco’s marginal tax rate at 24.6 percent, so the company’s after-tax cost of debt equals 3.7 percent. To weight the after-tax cost of debt and cost of equity, we set the target capital structure equal to the company’s current-debt-to-value, excluding excess cash. Normally, we net excess cash against gross debt to determine the cost of capital, but since Costco has little net debt compared with its peer group, we assume the company will disgorge excess cash to increase leverage. Adding together the weighted contribu- tions from debt and equity, WACC equals 8.0 percent. Always estimate the WACC in a manner consistent with the principles of free cash flow. For example, since free cash flow is the cash flow available to all financial investors, the company’s WACC must also include the expected return for each class of investor. In general, the cost of capital must meet the following criteria: • It must include the cost of capital for all investors—debt, preferred stock, common stock, and so on—since free cash flow is available to all investors, who expect compensation for the risks they take. • Any financing-related benefits or costs, such as interest tax shields, not included in free cash flow must be incorporated into the cost of capital or valued separately using adjusted present value.2 • WACC must be computed after corporate income taxes (since free cash flow is calculated in after-tax terms). • It must be based on the same expectations of inflation as those embed- ded in forecasts of free cash flow. • The duration of the securities used to estimate the cost of capital must match the duration of the cash flows. EXHIBIT 15.1  Costco: Weighted Average Cost of Capital (WACC) % Source of capital Target proportion of total capital Cost of capital Marginal tax rate After-tax cost of capital Contribution to weighted average Debt 10.4 4.9 24.6 3.7 0.4 Equity 89.6 8.5 8.5 7.6 WACC 100.0 8.0 2 For most companies, discounting forecast free cash flow at a constant WACC is a simple, accurate, and robust method of arriving at a corporate valuation. If, however, the company’s target capital structure is expected to change significantly—for instance, in a leveraged buyout—WACC can overstate (or understate) the impact of interest tax shields. In this situation, you should discount free cash flow at the unlevered cost of equity and value tax shields and other financing effects separately (as described in Chapter 10).