Introduction to Corporate Finance

11: Risk and Capital Budgeting

11-1b WEIGHTED AVERAGE COST OF CAPITAL (WACC)

In Chapter 7, we learned that the expected return on a portfolio of two assets equals the weighted average

of the expected returns of each asset in the portfolio. We can apply that idea to the problem of selecting

an appropriate discount rate for a company that has both debt and equity in its capital structure. Imagine

that Croc-in-a-Box Ltd, a chain of fast-food stores in the Northern Territory, has $100 million of ordinary

shares outstanding, on which investors require a return of 15%. In addition, the company has $50 million

in bonds outstanding that offer a 9% return.^3 To simplify our discussion, we hold the company’s overall

risk constant by assuming that the investments being considered do not change either the company’s cost

structure or its financial structure. Using this information, we can answer the question: What rate of

return must the company earn on its investments to satisfy both groups of investors?

The Basic Formula

The answer lies in a concept known as the weighted average cost of capital (WACC). Let D and E denote

the market value of the company’s debt and equity securities, respectively, and let rd and re represent the

rate of return that investors require on bonds and shares. The WACC is the simple weighted average of

the required rates of return on debt and equity, where the weights equal the percentage of each type of

financing in the company’s overall capital structure.^4

Eq. 11.3 =

+











 +

+











WACC 

D

DE

r

E

DE

der

3 The return we have in mind here is the yield to maturity (YTM) – developed in Chapter 4 – on the company’s bonds. Unless the bonds sell

at par, the coupon rate and the YTM will be different, and the YTM provides a better measure of the return that investors who purchase the

company’s debt can expect.

4 As a practical matter, companies in many countries can deduct interest payments to bondholders when they calculate taxable income. If a

company’s interest payments are tax deductible, and if the corporate tax rate equals Tc, we have the following:

(^) WACC D
DE
Tr

E

DE

= () (^1) cd re

• 
  









−+

+









We address this important adjustment for tax-deductible interest later in this chapter, after we have fully developed the key concepts.

LO11.2

TABLE 11.2 THE EFFECT OF FINANCIAL LEVERAGE ON SHAREHOLDER RETURNS

Account Company A Company B

Assets $100 million $ 100 million

Debt (interest rate = 8%) $ 0 (0%) $50 million (50%)

Equity $100 million (100%) $50 million (50%)

When return on assets equals 20%

EBIT $20 million $20 million

Less: Interest (^0) 4 million (0.08 × $50 million)
Cash to equity $20 million $16 million
ROE $20 million/$100 million = 20% $16 million/$50 million = 32%
When return on assets equals 5%
EBIT $5 million $5 million
Less: Interest 0 4 million (0.08 × $50 million)
Cash to equity $5 million $1 million
ROE $5 million/$100 million = 5% $1 million/$50 million = 2%
weighted average cost of
capital (WACC)
The after-tax weighted
average required return on
all types of securities issued
by a company, in which the
weights equal the percentage
of each type of financing in
a company’s overall capital
structure