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Learn Financial Modeling : Discounted Cash Flow statement (DCF) Methodology

4. calculate the Weighted Average Cost Of Capital

Before we even begin what I want to do is just discuss what WACC is and why we use it so WACC is the weighted average cost of capital it is a blended rate of return for all the capital providers of a company technically they're if a company had preferred stock you could include that in the WACC calculation now many practitioners don't do this because preferred is not a very common part of capital structure and if it is it's it's usually pretty small but nonetheless from an academic standpoint es you would want to include it now.

You're probably saying well why are we using WACC as the discount rate for our cash flows well just to recall this is an unlevered free cash flow analysis to recall what an unlevered free cash flow analysis is it is before the payments of interest EBI is before interest expense in other words these are cash flows that are available to all providers of capital not just the equity investors had we used a levered free cash flow approach the appropriate discount rate would have been cost of equity now WACC as you can see accounts for everyone that and so to make this an apples-to-apples analysis we should use WACC to discount these cash flows back to the present now that we understand why we use WACC let's now start tackling this section so the first thing we're going to have to do is reference share price so given that our valuation date is Mai 2018 let's reference the share price on that date

Regarding the diluted share count we're going to use the x number of shares you see now what do we mean by diluted shares outstanding well company has basic share account but you typically get from the front page of the filing but that's not really all the claims of ownership on a company dilution accounts for all the different ownership claims so those claims are rising from options warrants convertible debt or convertible preferred that are in the money so we want to account for all the different ownership claims that's why we're using diluted share account

Next in our list you see cost of debt and we've got tax rate and then after-tax cost of debt well you're probably wondering well why are we using after-tax cost of debt well to answer that question let's take a look at our free cash flow build up as we mentioned before this is an unlevered free cash flow approach which is before the payments of interest but we know something very special about debt and that is interest expense provides a real tax shield to companies who pay taxes of course so that interest expense reduces taxable income in some cases a substantial amount so because we're doing an unlevered free cash flow analysis some might think we're ignoring the effect of interest tax shields the fact is we are accounting for it we're accounting for it in our WACC calculation and that's why we take the after-tax cost of debt

This after-tax cost of debt represents the interest tax shield that the company experiences by using debt in their capital structure so to calculate after-tax cost of debt would take cost of debt times 1 minus the tax rate and we get 3.7 percent so you can see that that is significantly though lower than the 5 percent and again it's because of the interest tax shield now cause of debt is not a very highly debatable topic if you're dealing with a company usually use yield to worst and if you're using comparable company debt you usually use yield to maturity practitioners as well as academics don't really butt heads on this cost of equity on the other hand is a highly debatable topic and you know Business School professors versus practitioners tend to disagree on what should what cost of equity should be and it's highly debatable compared to cost of debt because with cost of debt you know what you're getting principal plus interest expense with cost of equity you don't really know what you're getting because it's a combination of potential dividend payments and price appreciation so some of the competing models that exist are farm of french-- dividend discount model as well as capital asset pricing model now we're going to focus on what practitioners use which is capital asset pricing model and that is equal to the risk-free rate plus beta times the market risk premium now this is essentially the formula for the security market line of a given market so assume that we did that analysis and we came up with 12.36%

By the Way the market risk premium is very subjective you can see the market risk premium table depending on what type of average you take (geometric , Arithmetic) the market risk premium varies a lot. To make is consistent we took the Risk Premium Arithmetic Average for the period 1928-2016 which is 7.96.

So debt holders request 12 that we know what our costs are for debt and equity let's now figure out what our capital structure what our target capital structure will be now that's sort of an important point you want to in your WACC calculation use what's the target capital structure for most mature companies which we will assume for our model here the existing capital structure is the target capital structure is the target capital that you typically want to use market values for both debt and equity but many times you don't have market values for debt so what you want to do is if you know your valuation date is let's say in this case May 2018 the 2017 the latest numbers available before that balance sheet numbers will be valuation date so we could go ahead and use our debt as well debt figure from 2017 given that that book value is a good proxy for market value so to summarize if you don't have market value figures for debt book values and acceptable proxy so let's go ahead and reference the book value while our equity is going to be share price times the diluted share count

So my debt weighting is going to be the debt divided by total capital while the equity weighting is equity divided by the total capital you can see that this adds up to one hundred percent and it should and again if there were preferred stock you would do the same thing figure out the amount of preferred that's in the capital structure and apply a weighting there as well so now that we have our debt weighting as well as our equity weighting we can calculate WACC so WACC again it's going to be a blended rate of return so if we have our equity weighting we can multiply that by cost of equity plus our debt weighting times after-tax cost of debt and this should give us twelve percent so that's going to be our cost of capital now if we go ahead and link that into our model you'll see that our cash flows will start to update with the appropriate present values because we've now inserted the discount rate and now we're going to assume that WACC doesn't change in the terminal value period I mean for he terminal value so we're going to use twelve percent again and again our stage two has now been updated with the correct present value so now that we've actually calculated WACC and brought that into the model we could go ahead and calculate enterprise value in our PART 5