Composite, or Weighted Average, Cost of Capital, WACC 239
(6-7)
Here wd, wps, and wceare the weights used for debt, preferred, and common equity,
respectively.
Every dollar of new capital that NCC obtains will on average consist of 30 cents of
debt with an after-tax cost of 6.6 percent, 10 cents of preferred stock with a cost of
10.3 percent, and 60 cents of common equity with a cost of 14.5 percent. The average
cost of each whole dollar, the WACC, is 11.7 percent.
Two points should be noted. First, the WACC is the weighted average cost of each
new, or marginal, dollar of capital—it is not the average cost of all dollars raised in the
past. We are primarily interested in obtaining a cost of capital to use in discounting fu-
ture cash flows, and for this purpose the cost of the new money that will be invested is
the relevant cost. On average, each of these new dollars will consist of some debt,
some preferred, and some common equity.
Second, the percentages of each capital component, called weights, could be based
on (1) accounting values as shown on the balance sheet (book values), (2) current mar-
ket values of the capital components, or (3) management’s target capital structure,
which is presumably an estimate of the firm’s optimal capital structure. The correct
weights are those based on the firm’s target capital structure, since this is the best estimate of
how the firm will, on average, raise money in the future. Recent survey evidence indicates
that the majority of firms do base their weights on target capital structures, and that
the target structures reflect market values.
11.7%.
0.3(11.0%)(0.6)0.1(10.3%)0.6(14.5%)
WACC wdrd(1T)wpsrpswcers
WACC Estimates for Some Large U.S. Corporations
Our table presents some recent WACC estimates as calcu-
lated by Stern Stewart & Company for a sample of corpora-
tions, along with their debt ratios.
These estimates suggest that a typical company has a
WACC somewhere in the 7 to 13 percent range and that
WACCs vary considerably depending on (1) the company’s
risk and (2) the amount of debt it uses. Companies in riskier
businesses, such as Intel, presumably have higher costs of
common equity. Moreover, they tend not to use as much
debt. These two factors, in combination, result in higher
WACCs than those of companies that operate in more stable
businesses, such as BellSouth. We will discuss the effects of
capital structure on WACC in more detail in Chapter 13.
Note that riskier companies may also have the potential
for producing higher returns, and what really matters to
shareholders is whether a company is able to generate re-
turns in excess of its cost of capital.
Book Value
Companya WACCb Debt Ratioc
General Electric (GE) 12.5 60.2%
Coca-Cola (KO) 12.3 11.5
Intel (INTC) 12.2 2.9
Motorola (MOT) 11.7 31.5
Wal-Mart (WMT) 11.0 36.3
Walt Disney (DIS) 9.3 31.0
AT&T (T) 9.2 23.1
Exxon Mobil (XOM) 8.2 9.1
H.J. Heinz (HNZ) 7.8 75.4
BellSouth (BLS) 7.4 42.2
Notes: a
bTicker symbols are shown in parentheses.
Values are from http://www.sternstewart.com,The 2000 Stern
Stewart Performance 1000.c
This is Long-term debt/(Long-term debt Equity), obtained from
http://yahoo.marketguide.com.
Source: Various issues of Fortune, the General Electric web site,
http://www.ge.com,and the Stern Stewart & Co. web site, http://www.
sternstewart.com.
236 The Cost of Capital
