Understanding Weighted Average Cost of Capital: A Pedagogical Application
Sam G. Berry, Carl E. Betterton, Iordanis Karagiannidis · 2014
We offer a pedagogical application of the capital structure decision-making process. The application consists of a two-stage interactive spreadsheet model by which the student assumes the role of financial manager. The student first performs construction and analysis of six traditional capital structure scenarios to find the optimal debt level - the level that minimizes weighted average cost of capital (WACC) and maximizes firm value - then applies Monte Carlo simulation to those scenarios. During their investigation of alternative capital structure scenarios, students must deal with the reality that WACC components, thus WACC itself, are stochastic variables. The capital structure model has proven very helpful for students to investigate and better understand the relationship between debt and equity capital components in their relative effects on WACC andfirm value, and also to appreciate the impact on estimated WACC of uncertainty and variability in its components.(ProQuest: ... denotes formulae omitted.)INTRODUCTIONIn truth, not even the chairman of the Federal Reserve Board knows how to identify a firm 's precise optimal capital structure or how to measure the effects of capital structure changes on stock prices and the cost of capital. In practice, capital structure decisions must be made using a combination of judgment and numerical analysis. (Brigham and Houston, 2010. p.486).The weighted average cost of capital (WACC) is an invaluable tool for use by financial managers in capital budgeting and business valuation analyses, and consequently, is a key topic in financial management courses. A continuing need exists for improved methods of teaching and learning this important topic. In a survey of 392 CFOs Graham and Harvey (2001) find that financial executives readily use business school techniques like net present value (NPV) and the capital asset pricing model (CAPM), but are much less likely to follow capital structure guidance from academia. Graham and Harvey (2001) suggest an explanation for this behavior might be that business schools are better at teaching capital budgeting and the cost of capital than at teaching capital structure. Citing this need for better capital structure teaching methods, Hull (2008) offers a pedagogical spreadsheet application of the capital structure decision-making process for a firm issuing debt to retire equity. Continuing the effort to produce improved teaching methods for capital structure, our purpose in this paper is to describe pedagogy that includes an experiential process for students to explore alternative mixes of debt and equity in the firm's capital structure and to observe the impact of their choices upon WACC and common stock price.The traditional approach to estimating the cost of invested capital is to compute a WACC using point estimates of each input (Keown, Martin, and Petty, 2011 ; Van Home and Wachowicz, 2001; and Welch, 2010). In reality however, there is uncertainty associated with these inputs. Some of the parameters in the WACC, such as the unlevered beta and market risk premium, are not known with certainty due to their stochastic nature or because they are not under the firm's control. These variable inputs can add to the variability of WACC results. An approach to estimating WACC that explicitly addresses this uncertainty is to identify and quantify the uncertainty in individual WACC parameter estimates, then describe the uncertainty around the expected WACC via Monte Carlo simulation. This paper describes use of both the traditional and Monte Carlo approaches as a means for students to (a) investigate and better understand the relationship between debt and equity in the capital structure, WACC, and firm value and (b) appreciate the impact on estimated WACC of uncertainty and variability in its components.The remainder of this paper is organized as follows: The next section describes the basic spreadsheet model as used by students. …