Principles of Corporate Finance_ 12th Edition

224 Part Two Risk

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When firms force the use of a single company cost of capital, risk adjustment shifts from

the discount rate to project cash flows. Top management may demand extra-conservative

cash-flow forecasts from extra-risky projects. Or they may refuse to sign off on an extra-risky

project unless NPV, computed at the company cost of capital, is well above zero. Rough-and-

ready risk adjustments are better than none at all.

Debt and the Company Cost of Capital

We defined the company cost of capital as “the expected return on a portfolio of all the

company’s outstanding debt and equity securities.” Thus the cost of capital is estimated as a

blend of the cost of debt (the interest rate) and the cost of equity (the expected rate of return

demanded by investors in the firm’s common stock).

Suppose the company’s market-value balance sheet looks like this:

The values of debt and equity add up to overall firm value (D  + E  = V) and firm value V

equals asset value. These figures are all market values, not book (accounting) values. The

market value of equity is often much larger than the book value, so the market debt ratio D/V

is often much lower than a debt ratio computed from the book balance sheet.

The 7.5% cost of debt is the opportunity cost of capital for the investors who hold the

firm’s debt. The 15% cost of equity is the opportunity cost of capital for the investors who

hold the firm’s shares. Neither measures the company cost of capital, that is, the opportu-

nity cost of investing in the firm’s assets. The cost of debt is less than the company cost

of capital, because debt is safer than the assets. The cost of equity is greater than the com-

pany cost of capital, because the equity of a firm that borrows is riskier than the assets.

Equity is not a direct claim on the firm’s free cash flow. It is a residual claim that stands

behind debt.

The company cost of capital is not equal to the cost of debt or to the cost of equity but is a

blend of the two. Suppose you purchased a portfolio consisting of 100% of the firm’s debt and

100% of its equity. Then you would own 100% of its assets lock, stock, and barrel. You would

not share the firm’s free cash flow with anyone; every dollar that the firm pays out would be

paid to you.

The expected rate of return on your hypothetical portfolio is the company cost of capital.

The expected rate of return is just a weighted average of the cost of debt (rD = 7.5%) and the

cost of equity (rE = 15%). The weights are the relative market values of the firm’s debt and

equity, that is, D/V = 30% and E/V = 70%.^3

Company cost of capital = rD D/V + rE E/V

= 7.5 × .30 + 15 × .70 = 12.75%

This blended measure of the company cost of capital is called the weighted-average cost

of capital or WAC C (pronounced “whack”). Calculating WACC is a bit more complicated

than our example suggests, however. For example, interest is a tax-deductible expense for

Asset value 100 Debt D = 30 at 7.5%

Equity E = 70 at 15%

Asset value 100 Firm value V =  100

(^3) Recall that the 30% and 70% weights in your hypothetical portfolio are based on market, not book, values. Now you can see why.
If the portfolio were constructed with different book weights, say 50–50, then the portfolio returns could not equal the asset returns.