Introduction to Corporate Finance

11: Risk and Capital Budgeting

Modifying the Basic WACC Formula

The WACC formula can be modified to accommodate more than two sources of financing. For instance, suppose

a company raises money by issuing long-term debt, D, equity, E, and preferred shares, P. Denoting the respective

required return on each security by rd, re, and rp, we can determine the WACC (still ignoring taxes) as follows:

=

++











 +

++











 +

++











WACC 

D

DEP

r

E

DEP

r

P

DEP

derp

example

The Smith & Jones Company has one million ordinary

shares outstanding, which currently trade at a price

of $50 per share. The market value of the ordinary

shares is therefore $50 million ($50 per share ×

1 million shares). The company believes that its

shareholders require a 15% return on their investment.

The company also has $47.1 million (par value) in

five-year, fixed-rate notes with a coupon rate of 8%

and a YTM of 7%. Because the yield on these bonds

is less than the coupon rate, they trade at a premium.

The current market value of the five-year notes is $49

million. Lastly, the company has 200,000 outstanding

preferred shares, which pay an $8 annual dividend

and currently sell for $80 per share. The market value

of the preferred shares is therefore $16 million ($80

per share × 200,000 shares) and the rate of return on

the preferred shares is 10% ($8 annual dividend ÷ $80

current price). What is the company’s WACC?

Begin by calculating the market value of each

security. Smith & Jones has $50 million in ordinary

shares, $49 million in long-term debt and $16 million

in preferred shares for a total capitalisation of $115

million. Next, determine the required rate of return

on each type of security. The rates on ordinary shares,

long-term debt and preferred shares are 15%, 7% and

10%, respectively. Plug all these values into the WACC

equation to obtain 10.9%:

WACC

$49

$115

7%

$50

$115

15%

$16

$115

10% 10.9%

=









×+









×

+







×=

LO11.2

> >

Dividend yield (%)

Year relative to liberalisation

6

5

4

3

2

–5 –3 –2 –1 0 1 2 3 4 5

5.5

4.5

3.5

2.5

–4

Source: Cengage Learning

Beth Acton, former Vice

President and Treasurer of

Ford Motor Co.

‘For us, it’s a very critical

calculation because we

use it to assess product

programs, to assess other

capital investments, and to

analyse acquisitions.’

See the entire interview on

the CourseMate website.

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