Weighted Average Cost of Capital

INTRODUCTION: This session long project looks at the calculations used to determine the weighted average cost of capital (WACC). This SLP calculates the WACC for my SLP company – McDonalds, discusses how those calculations were arrived at and briefly describes WACC and what investors use it for. COMPANY NAME: McDonalds Inc Balance sheet date: 31 DEC 07 Market values date: 1 SEP 08 SOURCEBOOK VALUEMARKET VALUEPROPORTIONSCOST (%)PRODUCT (a)(b)(c)(d)(e)(f) = (d) x (e) Short term liabilities4498. 54498. 50. 05380. 015180. 008 Long term liabilities9613. 49613. 40. 11510. 02720. 0031 Shareholders’ Equity69440694400. 83110. 024490. 0204 Total83551. 983551. 91 0. 0243 The basic way these numbers were arrived at was using the methods described in the session long project in module 4. The book values in column (b) are values that appeared in the most recent balance sheet of McDonalds. These totals were added together all of the items that appear under shareholders’ equity into one number – the total. The total of the book value is equal to the ‘book’ or ‘balance sheet’ value of the firm’s assets.

In column (c) insert your estimates of the ‘market values’. •For short term liabilities: you are to assume that the market value is equal to the ‘book value’. This again was determined from the balance sheet and calculations of SLP module # 2 •For long term liabilities – use the present value of the long term liabilities, I used the estimated totals in SLP 2. •For equity – the market value of equity is the total number of shares outstanding times the market price per share as of the date that you are working on the SLP. As of 1 SEP 08 the total shares outstanding for McDonalds was 1. 2 billion at a price of $62 per share. This gave me the totals for shareholders equity. Once these actions were complete, I total the three items in the market value column, column (c), to find the market value of the enterprise- $83. 5 billion. In column (d) insert the proportion of each item. I divided each number in column (c) by the TOTAL of this column. The sum of these proportions adds up to 1. 0000. In column (e) you insert the cost of each of the sources of financing: •For short term liabilities please find out what is the present rate of interest that companies pay on short term loans.

In this case that was 2. 3%. The cost of short term liabilities is the after tax cost, that is: the interest rate times (1 – T), where T is the corporate tax rate that you may assume T = 0. 34 (that is 34 %. ). In this case, the calculation was as follows: . 023 (1-. 34) = . 023(. 66) = . 0538% •For long term liabilities: I assumed that McDonalds pays on its long term liabilities an interest rate that is about 1% higher than the present yield to maturity of a 5-year US Government bond. I found out the present yield to maturity on a 5-year US Government bond, 3. 125% and then added 1% to that yield.

You then multiply the result by (1 – T) because interest on company’s debt are deductible for tax purposes and the effective after tax cost of debt is the yield the company is to pay times (1 – T). .0312(1-. 34) = . 0312(. 66) = . 0272 •For equity: I used the beta of McDonalds and the computation of the cost of equity from the previous report of the Session Long Project to insert the cost of equity (in %). McDonald’s beta is 1. 07. 1. 07 x . 07 = . 0749 .0749 + 2. 07 = 2. 1449 2. 1449 is the cost of equity for McDonalds. Finally, I added add up the first three numbers in column (f).

The sum of these numbers is your company’s weighted average cost of capital (WACC. ), which is 2. 43%. The weighted average cost of capital (WACC) is the rate that a company is expected to pay to finance its assets. WACC is the minimum return that a company must earn on existing asset base to satisfy its creditors, owners and other providers of capital. Companies raise money from a number of sources: common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, and so on. Different ecurities are expected to generate different returns. WACC is calculated taking into account the relative weights of each component of the capital structure. Broadly speaking, the assets of a company are financed by either debt or equity. WACC is the average of the cost of each of these sources of financing weighted by their respective usage in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it borrows. A firm’s WACC is the overall required return on the firm as a whole. It is the appropriate discount rate to use for cash flows similar in risk to the overall firm.

REFERENCES: www. msn money. com http://www. investopedia. com/terms/ www. wikepedia. com McDonalds – SLP, Module 4, Finance 501 Michael Kauffman September 1, 2008 Corporate Finance FIN 501 INTRODUCTION: This session long project looks at the calculations used to determine the weighted average cost of capital (WACC). This SLP calculates the WACC for my SLP company – McDonalds, discusses how those calculations were arrived at and briefly describes WACC and what investors use it for. COMPANY NAME: McDonalds Inc Balance sheet date: 31 DEC 07 Market values date: 1 SEP 08

SOURCEBOOK VALUEMARKET VALUEPROPORTIONSCOST (%)PRODUCT (a)(b)(c)(d)(e)(f) = (d) x (e) Short term liabilities4498. 54498. 50. 05380. 015180. 0008 Long term liabilities9613. 49613. 40. 11510. 02720. 0031 Shareholders’ Equity69440694400. 83110. 024490. 0204 Total83551. 983551. 91 0. 0243 The basic way these numbers were arrived at was using the methods described in the session long project in module 4. The book values in column (b) are values that appeared in the most recent balance sheet of McDonalds.

These totals were added together all of the items that appear under shareholders’ equity into one number – the total. The total of the book value is equal to the ‘book’ or ‘balance sheet’ value of the firm’s assets. In column (c) insert your estimates of the ‘market values’. •For short term liabilities: you are to assume that the market value is equal to the ‘book value’. This again was determined from the balance sheet and calculations of SLP module # 2 •For long term liabilities – use the present value of the long term liabilities, I used the estimated totals in SLP 2. For equity – the market value of equity is the total number of shares outstanding times the market price per share as of the date that you are working on the SLP. As of 1 SEP 08 the total shares outstanding for McDonalds was 1. 12 billion at a price of $62 per share. This gave me the totals for shareholders equity. Once these actions were complete, I total the three items in the market value column, column (c), to find the market value of the enterprise- $83. 5 billion. In column (d) insert the proportion of each item.

I divided each number in column (c) by the TOTAL of this column. The sum of these proportions adds up to 1. 0000. In column (e) you insert the cost of each of the sources of financing: •For short term liabilities please find out what is the present rate of interest that companies pay on short term loans. In this case that was 2. 3%. The cost of short term liabilities is the after tax cost, that is: the interest rate times (1 – T), where T is the corporate tax rate that you may assume T = 0. 34 (that is 34 %. ). In this case, the calculation was as follows: . 023 (1-. 4) = . 023(. 66) = . 0538% •For long term liabilities: I assumed that McDonalds pays on its long term liabilities an interest rate that is about 1% higher than the present yield to maturity of a 5-year US Government bond. I found out the present yield to maturity on a 5-year US Government bond, 3. 125% and then added 1% to that yield. You then multiply the result by (1 – T) because interest on company’s debt are deductible for tax purposes and the effective after tax cost of debt is the yield the company is to pay times (1 – T). .0312(1-. 34) = . 0312(. 66) = . 0272 For equity: I used the beta of McDonalds and the computation of the cost of equity from the previous report of the Session Long Project to insert the cost of equity (in %). McDonald’s beta is 1. 07. 1. 07 x . 07 = . 0749 .0749 + 2. 07 = 2. 1449 2. 1449 is the cost of equity for McDonalds. Finally, I added add up the first three numbers in column (f). The sum of these numbers is your company’s weighted average cost of capital (WACC. ), which is 2. 43%. The weighted average cost of capital (WACC) is the rate that a company is expected to pay to finance its assets.

WACC is the minimum return that a company must earn on existing asset base to satisfy its creditors, owners and other providers of capital. Companies raise money from a number of sources: common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, and so on. Different securities are expected to generate different returns. WACC is calculated taking into account the relative weights of each component of the capital structure.

Broadly speaking, the assets of a company are financed by either debt or equity. WACC is the average of the cost of each of these sources of financing weighted by their respective usage in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it borrows. A firm’s WACC is the overall required return on the firm as a whole. It is the appropriate discount rate to use for cash flows similar in risk to the overall firm. REFERENCES: www. msn money. com http://www. investopedia. com/terms/ www. wikepedia. com

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