Chapter 19 Financing and Valuation 493
bre44380_ch19_491-524.indd 493 09/30/15 12:07 PM
We calculated the market value of equity on Sangria’s balance sheet by multiplying its cur-
rent stock price ($7.50) by 100 million, the number of its outstanding shares. The company’s
future prospects are good, so the stock is trading above book value ($7.50 vs. $5.00 per share).
However, interest rates have been stable since the firm’s debt was issued and the book and
market values of debt are in this case equal.
Sangria’s cost of debt (the market interest rate on its existing debt and on any new borrow-
ing)^2 is 6%. Its cost of equity (the expected rate of return demanded by investors in Sangria’s
stock) is 12.4%.
The market-value balance sheet shows assets worth $1,250 million. Of course we can’t
observe this value directly, because the assets themselves are not traded. But we know what
they are worth to debt and equity investors ($500 + 750 = $1,250 million). This value is
entered on the left of the market-value balance sheet.
Why did we show the book balance sheet? Only so you could draw a big X through it. Do
so now.
Think of the WACC as the expected rate of return on a portfolio of the firm’s outstanding
debt and equity. The portfolio weights depend on market values. The expected rate of return
on the market-value portfolio reveals the expected rate of return demanded by investors for
committing their hard-earned money to the firm’s assets and operations.
When estimating the weighted-average cost of capital, you are not interested in past invest-
ments but in current values and expectations for the future. Sangria’s true debt ratio is not
50%, the book ratio, but 40%, because its assets are worth $1,250 million. The cost of equity,
rE = .124, is the expected rate of return from purchase of stock at $7.50 per share, the current
market price. It is not the return on book value per share. You can’t buy shares in Sangria for
$5 anymore.
Sangria is consistently profitable and pays taxes at the marginal rate of 35%. This tax rate
is the final input for Sangria’s WACC. The inputs are summarized here:
(^2) Always use an up-to-date interest rate (yield to maturity), not the interest rate when the firm’s debt was first issued and not the
coupon rate on the debt’s book value.
Cost of debt (rD) 0.06
Cost of equity (rE) 0.124
Marginal tax rate (Tc) 0.35
Debt ratio (D/V) 500/1,250 = 0.4
Equity ratio (E/V) 750/1,250 = 0.6
The company’s after-tax WACC is
WACC = .06 × (1 − .35) × .4 + .124 × .6 = .090, or 9.0%
● ● ● ● ●
Sangria’s enologists have proposed investing $12.5 million in the construction of a perpetual
crushing machine, which (conveniently for us) never depreciates and generates a perpetual
EXAMPLE 19.2 ● Using Sangria’s WACC to Value a Project
That’s how you calculate the weighted-average cost of capital. Now let’s see how Sangria
would use it.