Wacc Essay

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Chapter 13, ROIC and WACC Lakehead University Winter 2005 Role of the CFO The Chief Financial Officer (CFO) is involved in the following decisions: • Management Decisions • Financing Decisions • Investment Decisions 2 Performance Measurement Here are some measures of performance a company can use: • Earnings per share (EPS), growth in EPS • Return on invested capital (ROIC) • Return on equity • Economic profit (EP) 3 Performance Measurement What is ROIC? Pre-tax ROIC: EBIT Invested capital After-tax ROIC: (1 − t )EBIT , Invested capital where invested capital is the sum of (the book values of) notes payable, long-term debt, preferred stock and common equity, and t is the company’s tax rate. 4 Performance Measurement The firm’s economic profit, on the other hand, is given by EP = (ROIC − WACC) × Invested capital. 5 Weighted Average Cost of Capital (WACC) What is the WACC? Projects of levered firms are simultaneously financed with both debt and equity. The cost of a firm’s capital is a weighted average of the cost of debt and the cost of equity. Since interest is a tax-deductible expense, we must use the after-tax cost of debt. 6 Weighted Average Cost of Capital (WACC) The equation for a firm’s WACC is WACC = wd × (1 − t )kd + w ps × k ps + we × ke , where d , ps and e stand for debt, preferred stock and common equity, respectively, wi stands for the weight of item i in the firm’s capital structure, i = d , ps, e, and ki stands for the cost (in %) of item i. 7 Weighted Average Cost of Capital (WACC) What weights must be used in WACC calculations? How to calculate the cost of debt and the cost of equity? 8 Weighted Average Cost of Capital (WACC) A firm’s balance sheet can be represented as follows: Operating Assets Invested Capital Short-Term Debt NOWC Long-term

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