CH Ten

Weighted Average Cost of Capital & Corporate Performance Evaluation
Introduction to Corporate Financial Analysis

by George W. Blazenko
All Rights Reserved 2008
Chapter 10
Weighted Average Cost of Capital &
Corporate Performance Evaluation
Capital is money; capital is commodities. By virtue of it being value, it has acquired the occult ability
to add value to itself. It brings forth living offspring, or, at the least, lays golden eggs.
Karl Marx 1
1
Capital, vol. 1, ch. 4 (1867), Karl Marx (1818-83), German political theorist and social philosopher.
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Chapter Ten Contents

(10.1) ........................................................................................................................559
(10.2) ........................................................................................................................559
(10.3) ........................................................................................................................561
(10.4) ........................................................................................................................562
10.4.1 564
10.4.3 568
10.4.4 570
10.4.5 571
10.4.6 572
10.4.7 572
10.4.8 576
(10.5) ........................................................................................................................578
(10.6) ........................................................................................................................585
10.6.1 585
10.6.2 586
10.6.3 587
10.6.4 588
10.6.5 590
(10.7) ........................................................................................................................594
(10.8) ........................................................................................................................595
(10.9) ........................................................................................................................596
(10.10) ........................................................................................................................599
(10.11) ........................................................................................................................602
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(10.1)
Chapter 9 of this book makes the argument that a typical business investment does not grow. For
example, a particular Tim Hortons location cannot indefinitely increase the number of donuts and
cups of coffee it sells. It has many constraints: one of the most important of which is space.
Typical business investments do not grow, but companies do grow. Tim Hortons, for example,
grows by adding locations. Adding locations requires business expenditures like, for example,
trade capital (TC) and depreciable asset investment (CAPX). The current Chapter applies many
of the techniques we learned in Chapter 9 but to entire companies (that generally grow) rather
than to individual business investments (that generally do not grow). A bad analogy is that
Chapter 10 is a study of the forest while Chapter 9 is a study of individual trees in the forest.
Section 10.2 discusses the applications for which the WACC is appropriate. In section 10.3 the
WACC methodology for growing businesses is presented. Section 10.4 calculates the WACC for
a public firm, section 10.5 investigates a private firm. We illustrate the calculations for a public
firm for Canadian National Railway. One application of the WACC is corporate performance
evaluation. An aspect of this evaluation is residual income analysis that we investigate in section
10.6. Section 10.7 summarizes the chapter. Find practice problems and suggested readings at the
end of the chapter.
(10.2)
The weighted average cost of capital (WACC) is a methodology for using financial market
information to indirectly determine a discount rate for a firms assets. The WACC is a weighted
average of the discount rates for a firms financial assets. Because it is a weighted average of
discount rates, the WACC is itself a discount rate: a discount rate for existing assets. The cost of
capital is a general term for the discount rate applied to a particular asset valuation problem, like,
for example, capital expenditure analysis. The weighted average cost of capital is a methodology
to determine the cost of capital in a restricted set of applications.
The first application for which the WACC is appropriate is for business investment analysis for
expansion type projects. The WACC is a discount rate for existing assets. The implication of this
47
observation is that we can use the WACC in DCF analysis to value a firms existing assets. We
can also use it to value new ventures if these ventures have the same risk as existing operations.
In this case, we can describe these new ventures as expansion projects.
Even if a new venture is known to have greater or lesser risk than the firms existing business, the
WACC is, nonetheless, useful as a first approximation. For example, you might calculate the
WACC and then add or subtract a project specific increment to reflect the greater or lesser risk of
the project relative to existing operations. Our discussion of the corporate determinants of risk in
chapter 3 of this electronic book should be helpful in identifying risk differences between the
various operating ventures within in your firm.
The second application of the WACC is for corporate performance evaluation. The rate of return
on invested capital after tax and after depreciation is the rate of return that a firm earns for all of
its financial asset holders. One does not know whether this ROIC is high or low unless it is
benchmarked. The WACC is the appropriate benchmark. If the expected ROIC for a firm is
greater than its WACC, then the firm is able to generate returns for its financial asset-holders that
exceed their composite opportunity cost the WACC. Some of the financial characteristics of
such a firm are: (1) a high price/earnings ratio, (2) a high markettobook ratio, (3) a high
share price (or high shareholders wealth for a private corporation).
Using the WACC for corporate performance benchmarking is called Residual Income analysis and
we investigate it in some detail in section 10.6. This use of the weighted average cost of capital is
an important element of long term strategic planning and value creation for a firm. A good
reference book for using the WACC in this way is Valuation: Measuring and Managing the Value
of Companies by Copeland, Koller, Murrin, New York: John Wiley, 1993.
A firms equity can be valued with the discounted dividend model that we studied in chapter 8 of
this electronic book. However, many firms dont yet pay dividends and even if they pay
dividends, future dividends are difficult to assess. Instead, one can value a firms assets with free-
cash-flow valuation and then subtract an estimate of the market value of debt to estimate the
market value of equity, without having to predict dividends. Because the WACC is a discount rate
48
for a firms assets, the market value of assets can be estimated as predicted future free cash flow
(the numerator of DCF) discounted at the WACC. Thus, a third application of the WACC is for
valuing a firms equity without predicting dividends. This type of valuation for a firms equity is
commonly used in the investment industry in addition or instead of the discounted dividend
model. Equity valuation of this type is essential for big picture financial questions. For
example, you might be the founder of a private company and you want to liquidate your share
ownership for the purpose of retirement: what price should you ask per share in your firm?
Second, in a private firm, if want to sell new shares to finance new business activity, what price
should you ask? Third, what is the value of a share in a public firm, incorporating new strategic
initiatives that are not yet incorporated in share price? All these valuation questions require a
discount rate the WACC.
(10.3)
The weighted average cost of capital is a weighted average of the discount rates for all of the
financial assets of a firm. These assets include, for example, bonds, preferred shares, and common
shares. For the purpose of illustration, let us suppose that a firm has financed its operations, for
example, with long term debt (bonds) and common shares.
The WACC then, in this case, is calculated as:
after tax discount rate on discount rate

WACC = * weight + * weight
long term debt for common shares
The weights in the WACC are the fractions of the firm, which are capitalized by each of its
financial assets, respectively, using market value weights. The weight on debt is the debt to asset
ratio with market values for both debt and assets. The weight on equity is the equity to asset ratio
with market values for both equity and assets. An after corporate tax discount rate is used for
debt because interest is tax deductible for a firm, and therefore, is less costly than is equity
(recall that dividends are not tax deductible for a firm). The after corporate tax discount rate for
49
bonds is the yield to maturity times one minus the tax rate. The discount rate for equity is the
market capitalization rate.
The WACC is,
MVD MVE
WACC = (1-t)*rD * + MCR* (10.1)
MVD MVE MVD+MVE
where, rD is the expected rate on debt, t is the corporate tax rate, MCR is the market
capitalization rate on common equity, MVE is the market value of equity (that is, market cap),
MVD is the market value of debt, and the sum of MVD and MVE, MVD+MVE is the market
value of asset (also known as enterprise value).
(10.4) for a Public Firm

We can calculate the WACC for either a public firm or a private firm. However, the calculation is
easier for a public firm because more financial information is available for public firms. In
particular, market values for debt and equity are observable from financial markets so that the
weights of the WACC, the debt to asset ratio and the equity to asset ratio with market values, are
easily calculated. For a private firm, the market value weights must be estimated with other
methods. In this section of the electronic book, we investigate the weighted average cost of
capital for a public company and in the next section for a private company.
As an illustration of the WACC calculation, consider ABC Company Limited, a public firm, that
has the following market value balance sheet:
Exhibit 10-1: Market Value Balance Sheet for ABC Ltd.
L.T. Debt = $2,000,000

Assets = $8,000,000
Common Equity = $6,000,000
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A market value balance sheet in the set of assumed facts implies that ABC is a public company.
The market value of shares is the share price (in secondary market trading) times the number of
shares outstanding. The WACC can also be calculated for private firms. In the next section of
this chapter we do another example but the market value balance sheet is excluded from the set of
assumed facts and is replaced with the invested capital balance sheet. The implication of this
replacement is that the firm, in that case, is a private corporation. Then, we determine the market
value balance sheet (and the weights for WACC) by applying special techniques.
The market value of ABCs equity is the current share price times the number of shares
outstanding. ABC has one million shares, and therefore, the current share price is $6.0. The
market capitalization rate on ABCs equity is 12% per annum.
The market value of ABCs debt is $2,000,000 and its yield is 6% per annum. ABCs corporate
tax rate is 40%.
Given these assumed facts, we can calculate the WACC for ABC. Let us begin with the required
weights. The market value of ABCs assets is the sum of the market values of long-term debt and
common shares. The market value of debt relative to the market value of assets is the weight
for debt in the WACC calculation. The market value of equity relative to the market value of
assets is the weight for equity. These weights are 2,000,000/8,000,000 = 0.25% and
6,000,000/8,000,000 = 75.0% respectively.
The weighted average cost of capital for ABC is:
WACC = (1 0.40) 0.06 0.25 + 0.12 0.75 = 9.9%
This rate of return is the composite opportunity cost for ABCs financial asset holders:
shareholders and creditors. ABC can use this discount rate for capital expenditure analysis for
projects that are of the same risk as ABCs existing operations, for corporate performance
evaluation, and for questions of financial analysis that require a determination of asset value.
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10.4.1
Our above discussion is for a stylized company. Financial analysis is more difficult for actual
companies compared to stylized companies; we need more financial judgment for actual
companies. We apply this judgment to Canadian National Railway (CNR) for December 16,
2008. All of the information we need for CNRs WACC calculation we download from
www.yahoofinance.com on Dec 16, 2008. CNRs income statements and balance sheet from
yahoo finance are originally from EDGARonline at www.edgar-online.com. The worksheet
embedded to the following icon does all of the calculations for CNRs WACC.
CNR WACC
We begin by transforming the CNR balance sheet for fiscal years 2005-2007 into an invested
capital balance sheet. See the above embedded worksheet for details, but the result is,
Invested Capital Operating 31-Dec-07 31-Dec-06 31-Dec-05

Trade Capital -293,587 -480,535 -441,000
NFA+Other 22,846,793 19,451,411 18,148,000
Invested Capital 22,553,206 18,970,876 17,707,000
Invested Capital Financial

Debt 12,178,772 10,540,901 10,282,000
Equity 10,374,434 8,429,975 7,271,000
Invested Capital 22,553,206 18,970,876 17,553,000
At the end of fiscal year 2007, CNR has about 22.5 billion dollars of invested capital.
Next we calculate CNRs 2007 implied corporate tax rate. We call this rate implied because it is
not directly stated in financial statements. Instead we calculate it from financial statement
calculation done by CNRs accountants. On CNRs 2007 income statement Income Before Tax is
$2,758,496 and Income Tax Expense is $558,631 (see embedded spreadsheet). The later amount
52
is the former times CNRs 2007 tax rate. Consequently, CNRs 2007 implied corporate tax rate is
558, 631
the ratio, t = 20.25%.
2, 758, 496
Next, we calculate the rate that CNR pays on its debt, recognizing that CNR has many debt
issues, some public, some private, some short-term, some long-term. We calculate a weighted
average of the rates that CNR pays on all of its debt. To do this, we use a relation from chapter 2
between the Rate of Return on Invested Capital (ROIC) after tax and after depreciation, the
Rate of Return on Equity (ROE), and the rate paid on debt. The relation is,
Debt BVE
ROIC (1 t )* rD * ROE * (10.2)
IC IC
In the above spread sheet, we calculate CNRs 2007 ROICBOP as 13.0% and the 2007 ROEBOP as
10,540,901
26%. CNRs 2006 debt to capital ratio is . We use the 2006 ratio because we
18,970,876
calculate both2007 ROIC and 2007 ROE as BOP. One minus the debt to capital ratio is the
10,540,901
equity to capital ratio, 1 . Substitute, all of these numbers into Equation (10.2) to
18,970,876
determine the only remaining measure, the rate that CNR pays on their debt,
10,540,901 10,540,901
0.13 (1 0.2025)* rD * 0.26* 1
18,970,876 18,970,876
Solve this equation to determine that the weighted average rate that CNR pays on debt, rD =3.2%.
Next, we calculate the expected return on equity, MCR. Presume that CNR is a constant growth
firm. Then, we can use Equation (8.12) for constant growth expected return (CGER).
53
P
MCR= ROE 1 0 dy
BVE
P0
where, ROE is the forward rate of return on equity, is the market to book ratio, and dy is the
B
forward dividend yield.
P
On Dec 16, 2008, CNRs market to book ratio is 1.91 . Their price to forward earnings ratio
B
P
is 11.0 . The ratio of these two ratios is forward earnings to book equity which is the
E
forward ROE,
P
B E 1.91
ROE 17.36%
P B 11
E
Notice that CNRs forward ROE, 17.36%, is less than their 2007 realized ROE, which is 26%.
Financial analysts expect CNRs future profitability to be less than in 2007.
The current dividend yield for CNR on Dec 16, 2008 is 2.2%. We use the Appendix to Chapter 8
to transform the current dividend yield to the forward dividend, which is 2.5%. See the above
CNR WACC spreadsheet for the calculations. So, the MCR for CNR on Dec 16, 2008 is,
P
MCR= ROE 1 0 dy = 0.1736 1 1.91 *0.025 0.151
BVE
We retrieve CNRs market cap (MVE) from yahoo finance for December 16, 2008.
MVE=17,090,000.
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Because most large companies, including CNR have many debt issues, some private and some
public, it is hard to put an exact number on market debt value, MVD. Therefore, we use an
approximation. The approximation is based on the observation that most companies do not sell
debt (borrow) that is very long term. There are of course exceptions, but most corporate debt has
maturity significantly less than ten years. Over short maturities, debt contract rates never diverge
far from opportunity costs. The implication of this observation is that a good approximation to
MVD is the principal on debt, which is Debt on the invested capital balance sheet. Using this
approximation, at year-end 2007, MVD 12,178, 772 .
The sum of market cap (MVE) and MVD is the market value of assets (MVA), also called
Enterprise Value. CNRs MVA is MVE+MVD=17,090,000+ 12,178, 772 =$29,268,772.
We now have all of the variables required to calculate CNRs WACC,
12,178, 772 17, 090, 000

WACC = (1-0.2025)*0.032* + 0.151* = 9.9%
29, 268, 772 29, 268, 772
CNR can use this rate for the purposes that we discuss in section (10.2) above. One of the
applications for the WACC is corporate performance evaluation. We turn to this analysis now,
first, for a stylized company, and then for CNR.
10.4.3
Let us expand the information for the stylized company in our above example to illustrate how we
can use the WACC as a benchmark for corporate performance. In addition to the above
assumptions, suppose that:
- Predicted EBITDA in the upcoming year is $1,220,000,

- ABC grows at the rate of 4% per year,
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- the rate of economic depreciation, the rate of financial statement depreciation, and the rate of
depreciation for tax purposes, and maintenance capital expenditures all equal 2.5% of net
fixed assets as of year-end,
- the coupon rate on ABCs debt is 6% per annum (compounded and paid once per year).
Firms make incremental investments into their business activity for one of two reasons. First,
assets are likely subject to economic depreciation, which can be offset by refurbishing or replacing
assets. Recall that in chapter 9 of this electronic book, we defined economic depreciation as the
reduced ability of an asset to generate future cash flows. This depreciation can arise from either
the use or entropy of plant, property, and equipment. Investments made to offset this type of
depreciation are often call maintenance capital expenditures or sustaining capital
expenditures. Second, firms make incremental asset investments for the purpose of growth. We
verify in later analysis that ABCs maintenance and growth investments should indeed be made
because they are positive NPV.
Finally, with respect to assumed facts, let us suppose that ABC has the following invested capital
balance sheet:
Exhibit 10-2: Invested Capital Balance Sheet ABC Ltd.
Trade Capital = $1,000,000 L.T. Debt (Par value) = $2,000,000
Net Fixed Assets = $4,000,000 Common Equity = $3,000,000.

Invested Capital = $5,000,000 Invested Capital = $5,000,000
Recall that invested capital is the amount that a firm has invested into business activity on behalf
of financial asset holders. ABC has raised this amount by selling $2,000,000 in bonds and
$3,000,000 in equity (either through direct purchases of shares or indirectly through retained
earnings). Because the coupon rate and the yield on ABCs debt are both 6% per annum, the
market value and the book value (par value) of their bonds are equal.
With this expanded representation of ABC, the WACC is a benchmark for performance evaluation.
The rate of return on invested capital after tax and after depreciation (ROIC) is the rate of return
that ABC earns for its financial asset holders. A comparison between ROIC and the WACC
benchmarks the performance of ABC against a demanding standard: financial markets.
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In the upcoming year, financial statement depreciation is 0.025*4,000,000 = $100,000.

Therefore, ROIC after tax and after depreciation (predicted into the indefinite future) is:
ROIC after tax and after depreciation =
( EBITDA deprec) * (1 tax rate) (1,220,000-100,000)*(1-0.4)

= = 13.44%.
Invested Capital 5,000,000
This rate of return implies that ABC is earning (or is predicted to earn) 13.44% per annum for the
composite of their financial asset holders. Whether this value is high or low depends upon the
benchmark. The benchmark is the WACC. The fact that ROIC = 13.44% > WACC = 9.9%,
indicates that ABC is performing well for its financial asset holders. Financial asset holders cannot
earn, at least on average, a higher rate of return (i.e., the WACC) in alternative financial assets of
equal risk.
10.4.4
To assess CNRs corporate performance, we begin by calculating their forward ROIC from their
forward ROE. We use Equation (10.2) for this calculation.
When a financial analyst is forecast the future, BOP is the date of the latest available financial
statements, which for us is year-end 2007. Thus, CNRs debt to invested capital ratio (BOP) is
DEBT 12,178, 772

0.54 (see the invested capital balance sheet above for the numbers). At
IC 22,553, 206
year-end 2007 CNR has financed 54% of its business investment with debt. One minus this
amount, 46% is CNRs 2007 equity to invested capital ratio.
Finally, recall some calculations we did above for CNR: first, the implicit corporate tax rate is
20.25%, second, the rate paid on debt is 3.2%., and third, forward ROE is 17.36%. Put these
numbers into Equation (10.2) to determine CNRs forward ROIC,
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Forward ROIC (1 0.02025) *0.032*0.54 0.1736*0.46 =9.36%
This forward ROIC compares poorly against CNRs 9.9% WACC. Thus, at the current time, we
do not expect CNR to be a big wealth creator from business expansion. Further, given this poor
comparison, as investors, we are surprised that the market to book ratio, 1.91, is as great as it is.
While we have not done a complete financial analysis, these calculations suggest caution for
investors considering the purchase of CNR shares. CNR large 2007 ROE of 26% appears to have
arisen in large part from financial leverage rather than inherent business profitability. Despite
these cautions, CNRs MCR is 15.1%. If this amount is reasonable for an investor, and given
CNRs risk, then an equity investment might be reasonable. There is, however, considerable risk
in a CNR equity investment. If CNR does not meet the forward ROIC of 17.36%, then, given its
high financial leverage, shareholders are likely to suffer greatly.
10.4.5
Recall that the WACC is a discount rate for a firms expansion projects (i.e., projects with the
same risk as existing assets). If ROIC after corporate tax and after depreciation is greater than
the WACC, any business expansion is positive NPV. This positive value is consistent with a
growth orientation.
Consider a firm say DEF Corporation Ltd. that has ROIC after tax and after depreciation less
than its WACC. An important question for this firm is whether they should continue in business at
all. Does a predicted ROIC less than the WACC imply that a firm should liquidate assets, repay
liabilities, and pay a liquidating dividend to shareholders so that financial asset holders as a group
can reinvest elsewhere at a higher rate?
The general answer to this question is that in some cases, rates of return can be misleading and
must be interpreted with caution. This is one of those cases.
Presumably, DEF invested into business activity in the past when this investment was positive
NPV. Business activity doesnt always turn out as we would wish, and in this particular case,
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DEF is not as profitable as had been expected. We typically answer big picture financial
questions by considering values rather than rates of return. Whether or not DEF should liquidate
depends on the value of DEF operated as a going concern versus the value of DEF in
liquidation. If DEF operates as a going concern, its asset value is the amount that appears on its
market value balance sheet. If DEFs liquidation value is greater than this amount, DEF should
liquidate, repay liabilities, and pay a liquidating dividend to shareholders. Otherwise DEF should
continue in operation. DEF is not as profitable as had been expected but it is not bankrupt if it
can make interest payments and other fixed commitments (like principal repayment).
As an example of the liquidate versus continue to operate decision, suppose that DEFs invested
capital is composed of $500,000 in trade capital and $1,000,000 in plant, property, and
equipment. Suppose, in addition, that DEF can liquidate trade capital at 50 cents on the dollar.
Plant, property, and equipment can be sold at 90% of its book value. The value of DEF in
liquidation is, therefore, 0.5500,000 + 0.91,000,000 = $1,150,000. If the value of DEF as a
going concern is, say, $1,300,000, this amount is greater than the value of DEF when liquidated.
The optimal decision for DEF and its shareholders is to continue in operation.
10.4.6
The market to book ratio for a firm is a reflection of its operating performance. Recall from
Chapter 1 that a benchmark for the market to book ratio is one. Firms that have a marketto
book ratio greater than one have created wealth for their financial asset holders. The marketto
book ratio for ABCs assets is:
market value of assets $8,000,000

Markettobook ratio for assets = = = 1.60.
book value of assets $5,000,000
In this calculation we use invested capital as the book value of ABCs assets. The fact that ABCs
markettobook ratio is greater than one indicates that ABC is performing well for financial asset
holders. Every dollar that ABC invested into business activity in the past is now worth $1.60.
This wealth creation implies that ABCs growth orientation is, once more, justified.
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10.4.7
Performance evaluation, from an asset perspective, which we investigated in the previous sub-
section of this chapter, is most appropriate for internal financial analysts. The fundamental
question is how can a firms operations be improved to create wealth for all of the financial asset-
holders of a firm? Rather than performance evaluation from a firm perspective, we can also
undertake performance evaluation from an equity perspective. The fundamental question for an
external equity financial analyst is: how is the firm performing for shareholders. The essential
comparison is rate of return on equity (ROE) versus the market capitalization rate on equity.
The ROE for ABC is the expected net income per annum divided by the book value of equity. 2
Net Income (1-tax rate)*(EBITDA-deprec.-interest)

ROE = =
Book Equity Book Equity
0.6 * (1, 220,000 -100,000-0.06*2,000,000)

= = 20% per annum
3,000,000
In this ROE calculation, interest is the coupon rate of 6% on the $2,000,000 par value for bonds.
Notice that the ROE for ABC is greater than the market capitalization rate of 12%. This
comparison of rates implies, once more, that ABC is doing well for their shareholders. This
assessment is consistent with that from the asset perspective.
Does this favorable performance evaluation imply that an investor should purchase shares in
ABC? Once again, this is a case where rates of return can be misleading and must be treated with
caution. Big picture questions like should I purchase shares? depend upon values and not
rates of return directly. In the case at hand, the price you pay for a share depends upon whether
or not the equity market is informationally efficient. If the equity market is informationally
efficient, then the fact that the ROE is greater than the market capitalization rate is impounded in
the current share price. In other words, over the recent past, share price in ABC has likely
increased. If you purchase a share, the rate of return that you can expect to receive is your
2
In Chapter Two, deferred taxes were added in the calculation of ROE. The need for this greater precision is not
necessary in the current discussion because we do not, for simplicity, make the distinction between financial
statement depreciation and depreciation for tax purposes.
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opportunity cost, the market capitalization rate, not the ROE. Your opportunity cost rate of
return is just the same as the rate you will get on shares (or portfolio of shares) of the same risk as
ABC. The implication of this observation is that there is no necessary reason (i.e., other things
equal) to purchase a share in a firm based on a favourable comparison between ROE and the
market capitalization rate.
To verify these assertions, let us find the expected rate of return on ABC shares. We know that
this rate is 12% per annum, the market capitalization rate, but let us verify. Recall that ABC is a
growing firm, and therefore, the expected rate of return is dividend yield plus growth, see chapter
8 of this electronic book for a detailed justification of this assertion. Dividends in the upcoming
year are net income less retention for the purpose of growth.
First, let us find net income (NI):
NI = (1-tax rate)*(EBITDA-deprec.-interest) = 0.6*(1,220,000 - 100,000-120,000) = $600,000.
Second, let us find retained earnings. Because ABCs growth rate is 4% per annum, it must retain
4% of book value of equity (BVE) per year for reinvestment, which generates growth. Retained
earnings (RE) are, therefore,
RE = Retained Earnings = g*BVE = 0.04*3,000,000 = $120,000.
Recall from the invested capital balance sheet exhibit 10-2 that BVE is $3,000,000. Because
dividends equal net income less retained earnings, expected dividends in the upcoming year are
$600,000 - $120,000 = $480,000. Thereafter, dividends are expected to grow at 4% per year.
Also recall that the expected rate of return on a financial investment in ABC shares is dividend
yield plus growth:
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Expected Dividends $480,000

Expected Rate of Return = Growth = 0.04 = 12%.
Market Value of Equity $6,000,000
This rate of return indicates that what you get as an expected rate of return if you purchase a
share in ABC is not the expected ROE but the market capitalization rate. Further, and
alternatively, if you invest in other financial assets of equal risk, you also get 12%, the opportunity
cost.
Why is there equivalence between the expected rate of return on the investment in a financial asset
and its opportunity cost? Recognize that ABC is expected to be very profitable in the future. Not
only you and I, but also many other investors recognize this profitability. Thus, the expectation of
this profitability is reflected in share price. Because share price has increased in the recent past, if
you purchase a share of ABC today, your expected rate of return is the market capitalization rate,
which is just the rate of return you can expect on financial assets of equal risk. In other words,
the fact that the ROE is greater than the market capitalization rate does not imply that investors
should necessarily purchase shares.
The markettobook ratio for equity is another reflection of corporate operating performance.
For ABC:
market value of equity $6,000,000

Markettobook ratio for equity = = = 2.0
book value of equity $3,000,000
The fact that ABCs markettobook ratio is greater than one indicates, once more, that ABC is
performing well for shareholders. Every dollar that shareholders invested is now worth $2.0.
However, the decision for an investor on whether or not to purchase shares depends upon capital
market efficiency. We have argued that if equity markets are informationally efficient, there is no
necessary reason for a purchase.
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10.4.8
To illustrate that the WACC can be used for asset valuation, we can discount the asset cash flows
of ABC with the WACC and arrive at the value reported in ABCs market value balance sheet.
The asset value according to the principles of FCF valuation for ABC, is, in this instance,
FCF1
Asset Value =
WACC 0.04
The term FCF1 is free cash flow predicted in the upcoming year. Recall from Chapter 2 that free
cash flow (FCF) can be calculated as:
Free Cash flow = Funds from operations

- Incremental Investment in Business Activity
In our example, this amount can be calculated as
FCF = (1 t ) * ( EBITDA CCA) CCA TC Cap. Exp.
where,
t is the corporate tax rate,

CCA is Capital cost allowance,
TC is the incremental investment in trade capital assets,
Cap. Exp is capital expenditure for both maintenance of assets and for growth
Because we are predicting FCF, EBITDA in this expression is predicted EBITDA in the upcoming
year. In addition, in the upcoming year, financial statement depreciation is 0.025*4,000,000 =
$100,000. Recall, that we presume that CCA equals financial statement deprecation, which equals
maintenance capital expenditures. Thus, CCA = maintenance capital expenditures = $100,000. In
addition, we predict that in the future, ABCs invested capital will grow at 4% per annum. This
investment growth encompasses growth in both trade capital assets and depreciable assets.
63
Maintenance capital expenditures plus incremental trade capital investment plus growth capital
expenditures equal $100,000 + 0.04*1,000,000 + 0.04*4,000,000 = $300,000. Hence,
FCF = 0.6*($1,220,000 100,000) + $100,000 $300,000 = $472,000.
We have determined previously that ABCs WACC is 9.9%. Therefore, ABCs asset value is
FCF1 472,000
Asset Value = = = $8,000,000.
WACC 0.04 0.099 0.04
Recognize that this calculation confirms the asset value from ABCs market value balance sheet in
exhibit 10-1.
To complete our example of ABC Company Ltd., we demonstrate that the market value for
ABCs equity, which appears on the market value balance sheet, is also consistent with the
principles of DCF. Recall that because dividends equal net income less retained earnings,
expected dividends in the upcoming year are $600,000 - $120,000 = $480,000. Thereafter,
dividends are expected to grow at 4% per year. Also, we have assumed that the market
capitalization rate for ABCs equity is 12% per annum. Thus,
DIV1 480,000
Market value of Equity (MVE) = = = $6,000,000.
MCR - growth 0.12 0.04
The term DIV1 is the amount of dividends (in total) predicted in the upcoming year. In this
application of the discounted dividend model, we use the formula for the present value of a
growing perpetuity because ABC is a growing firm. This DDM valuation of equity is consistent
with the value that appears in the market value balance sheet in exhibit 10-1.
(10.5)
Calculating the WACC for a private firm is more difficult than for a public firm because market
values for debt (MVD) and equity (MVE), for the debt to asset and the equity to asset ratios, are
64
not observable from financial markets. For a private firm, MVD is easily estimated using the
methods we studied for bond valuation in chapter 7 of this electronic book. Alternatively, because
most corporate debt is relatively short-term in maturity, the book value of debt closely
approximates the market value in most cases.
There are a number of methods that one can use to estimate the market value of equity MVE for
use in the weights of the WACC. A crude estimate of the MVE is the P/E ratio for a firms
industry times predicted earnings for the private firm in question times the number of shares
outstanding. Another crude estimate for MVE is the market to book ratio for the industry times
the book value per share for the firm in question times the number of shares outstanding.
Methods with more demanding calculations yield exact values for WACC and MVA. For
example, one can use an iterative calculation for the market value of equity for the weights in the
WACC. Begin by guessing a value for the market value of equity (MVE) for the private firm.
Calculate the market value of debt (MVD) using the methods of chapter 7 of this electronic book.
An estimate of the market value of assets (MVA) is MVE + MVD. The weights for the WACC
are MVD/MVA and MVE/MVA. Find the FCF value of assets as the discounted value of
predicted future free cash flow with the WACC as the discount rate. Re-estimate the MVE as the
FCF value of assets less the MVD. With this new estimate of the MVE, repeat the above, that is,
iterate, until the estimate of MVE from FCF valuation converges to the MVE that is used in the
weights for the WACC. Upon convergence, the MVE, calculated as MVA-MVD, is consistent
with the MVE used for the weights of the WACC. This iterative method for calculating the
WACC is illustrated in problem #6 at the end of this chapter.
Alternatively, for a firm for which dividends can be reasonably predicted, one can use the
discounted dividend model from chapter 8 of this electronic book to estimate the MVE.
Last, if the value of assets and equity can be represented with a simple valuation formula, like the
present value of a growing perpetuity, then exact values for MVA and WACC can jointly be
determined as the solution to two equations with these two unknowns. It is this approach that we
use in this section on the WACC for a private firm.
65
We work with an example. PVI Company Ltd. has the following invested capital balance sheet:
Exhibit 10-3: Invested Capital Balance Sheet for PVI Ltd.
Trade Capital = $1,000,000 L.T. Debt (Par value) = $2,000,000
Net Fixed Assets = $4,000,000 Common Equity = $3,000,000.
Invested Capital = $5,000,000 Invested Capital = $5,000,000
PVI has invested $5,000,000 into business activity on behalf of financial asset-holders. They
have financed this investment by selling $2,000,000 of bonds to bondholders and $3,000,000 of
shares to common shareholders. The coupon rate on PVIs bonds equals the yield, 6%, and
therefore they trade at par. Trading at par means that the market value (MVD) and the par value
(BVD) of PVIs bonds are equal.3 PVI pays both dividends and coupons annually. Upcoming
coupons and dividends, respectively, are paid in exactly one year. The market capitalization rate
(MCR) for PVIs equity is 12%. PVIs tax rate is 40%.
Finally, with respect to assumed facts, PVIs predicted rate of return on invested capital before
depreciation and before tax is 24.4% per annum. Economic depreciation for PVIs depreciable
assets is 2.5% per annum of net fixed assets. Alternatively, we can measure depreciation as a
fraction of overall investment invested capital. Because depreciation is 0.025*4,000,000 =
$100,000, the rate of depreciation, when measure against invested capital, is $100,000/5,000,000
= 2%. Because economic depreciation on trade capital assets is likely close to zero, this rate of
depreciation is a weighted average of the rate of depreciation on each of ABCs assets, trade
capital and depreciable assets: 0.02 = 0.0*(1,000,000/5,000,000) +
0.025*(4,000,000/5,000,000). Because depreciation, measured relative to invested capital, is 2%
3
This assumption is a convenience for the analysis. In order to maintain an optimal financial structure, a
growing firm must borrow over time at the growth rate for the firm. In our analysis, in order not to have two
contract rates for debt, one for existing debt, and a predicted rate for future debt, it is convenient to presume that
the existing bonds trade at par. In this case, the coupon rate on existing debt is also the expected coupon rate for
debt that is to be issued in the future.
In the analysis of an actual firm, you can always work with a hypothetical recapitalization of debt to the
current market rate as an analytic convenience (i.e., repay existing debt and borrow at the current market rate of
interest in the economy). Total interest remains the same but the par value of debt might increase or decrease
depending upon whether the existing bonds are trading at a premium or a discount. This recapitalization does not
change total interest, or the market value of debt in the firm, and therefore, it does not impair the generality of your
analysis.
66
per year, operating cash flows fall 2 percent per year (before maintenance capital expenditures).
The government recognizes depreciation as a cost of business, and therefore, permits capital
cost allowances (CCA) as a deduction from taxable income. In our analysis, we presume that the
government offers CCA amounting to 2.5% of net fixed assets per year.4 We also presume that
PVI makes maintenance capital expenditures in the amount of 2.5% of net fixed assets at the end
of every year (or, equivalently, 2% of invested capital) to offset the effect of economic
depreciation.
Beyond the investments in depreciable assets that PVI makes for maintenance to prevent
economic depreciation, it also makes investments for growth. We presume that ABCs business
grows at the rate of 4% per annum. This growth requires year-end incremental investments in
trade capital assets and depreciable assets. Because growth in business activity is 4% per annum,
year-end growth investments must be 4% of invested capital.
For a private firm, there are a number of methods that one can use to estimate the market value of
equity for the weights of the WACC. If the value of assets and equity can be represented with a
simple valuation formula, like the present value of a growing perpetuity, then we can jointly
determine exact values for MVA and WACC as the solution to two equations with these two
unknowns. In our example of PVI Corporation, we use the formula for the present value of a
growing perpetuity, because PVI is expected to grow at a constant rate.
FCF1
Asset Value (MVA) =
WACC Growth
The term FCF1 is free cash flow predicted in the upcoming year. Recall from Chapter 2 that free
cash flow (FCF) can be calculated as:
4
In Canada, CCA is calculated with undepreciated capital cost of an asset class rather than with net fixed assets.
However, in our example because we presume that the rate for financial statement depreciation is the same as the
rate for capital cost allowances; book value for financial statement purposes, net fixed assets, is always the same as
the book value for tax purposes, the undepreciated capital cost. If one wishes to relax this assumption, an
adjustment for deferred income taxes is required. See chapter two of this electronic book for a discussion of
deferred income tax.
67
Free Cash flow = Funds from operations

- Incremental Investment in Business Activity
In our example, this amount can be calculated as
FCF = (1 t ) * ( EBITDA CCA) CCA TC Cap. Exp.
where,

CCA is Capital cost allowance,
TC is the incremental investment in trade capital assets,
Cap. Exp is capital expenditure for both maintenance of assets and for growth
Because we are predicting FCF, EBITDA in this expression is predicted EBITDA in the upcoming
year. Predicted EBITDA is predicted ROIC before tax and before depreciation times invested
capital. For PVI Corporation, EBITDA = 0.244*5,000,000 = $1,220,000. In addition, in the
upcoming year, financial statement depreciation is 0.025*4,000,000 = $100,000. Recall, that we
presume that CCA equals financial statement deprecation, which equals maintenance capital
expenditures. Thus, CCA = maintenance capital expenditures = $100,000. In addition, we predict
that in the future, ABCs invested capital will grow at 4% per annum. This investment growth
represents growth in both trade capital assets and depreciable assets. Thus, maintenance capital
expenditure plus incremental trade capital investment plus growth capital expenditures equal
$100,000 + 0.04*1,000,000 + 0.04*4,000,000 = $300,000. Hence,
FCF = 0.6*($1,220,000 100,000) + 100,000 $300,000 = 472,000.
Because FCF1 is $472,000, and projected growth is 4% per annum,
472,000
MVA = (10.3)
WACC 0.04
Equation (10.3) is the first of two that we need to jointly determine MVA and WACC. The
68
second equation defines WACC:
MVD MVE
WACC = (1 - t) * y * + MCR *
MVA MVA
where,

y is the yield on ABCs debt (not the coupon rate or the contract rate, y is market determined)
MVD is market value of debt,
MVE is market value of equity,
MVA is market value of assets
MCR is the market capitalization rate.
The weights in the WACC are the fractions of the firm that are capitalized by each of its financial
assets using market value weights. An after corporate tax discount rate is used for debt because
interest is tax deductible for a firm, and therefore, is less costly than is equity (recall that
dividends are not tax deductible for a firm). The discount rate for debt is its yield times one minus
the tax rate. Recognize that the yield is not the same as the contract rate on debt. The yield
reflects current market conditions. For example, if interest rates in the economy have fallen since
the debt was originally issued, then the yield on the debt is less than the contract rate on the debt.
The discount rate for equity is the market capitalization rate.
Because MVA = MVD + MVE,
MVD (MVA - MVD)

WACC = (1 - t) * y * + MCR *
MVA MVA
From the assumed facts for our PVI corporation example, we know that t=0.4, y=6%, MCR =
12%, MVD = 2,000,000. Substitute these values into the above equation for WACC,
69
168,000
WACC = 0.12 - (10.4)
MVA
Jointly solve for WACC and MVA with equations (10.3) and (10.4) (substitute one equation into
the other) to find that WACC = 9.9% and MVA = $8,000,000.
Of course, you recognize that PVI Corporation in this section is more or less identical to ABC
Corporation in the previous section of this chapter. Thus, any analysis we did for ABC
Corporation is equally applicable to PVI Corporation. The only distinction between ABC and
DEF Corporations is that ABC is public and PVI is private. Our point is that the WACC can be
calculated for a private firm. The calculations are somewhat more onerous: the WACC is
calculated in conjunction with a valuation of the private firms assets.
We jointly determine MVA and WACC with two equations. The first equation calculates MVA as
the discounted value of predicted future free cash flow with WACC as the discount rate. The
second equation defines the WACC as the weighted average of discount rates on the financial
MVD MVE
assets of the firm with the and the ratios as weights.
MVA MVA
There is one troubling aspect of our comparison between ABC, the public firm, and PVI, the
private firm. Even if a private and a public firm have identical operations, they are not likely
viewed as equivalent by financial markets. Other things equal, investors prefer public firms to
private firms because of liquidity. That is, an investment in a public firm is easily sold, whereas, a
similar investment in a private firm is not. Consequently, investors demand a liquidity premium
for owning the shares of a private firm compared to a public firm. This liquidity premium should
cause the share value of the private firm to be lesser than the share price of the public firm and,
correspondingly, the expected rate of return for the private firm should be greater. In our
example, the expected rate of return, the MCR for the private firm, PVI, should really be greater
than the MCR of the public firm, ABC. We leave required adjustments to the professional
judgment of the reader.
70
To complete our analysis of PVI Corporation (equivalently ABC corporation), we need to verify
that the investments they make for maintenance and for growth are positive NPV. In the
upcoming year, PVIs funds from operations is (1-t)*(EBITDA-CCA)+CCA is 0.6*(1,220,000-
100,000)+$100,000 = $772,000 per $5,000,000 invested in business activity. This amount is
772,000/5,000,000 = $0.1544 per $1 invested in business. This incremental free cash flow that a
$1 investment creates declines at 2% per year because of economic depreciation. Discounting at
the WACC, the NPV of $1 invested in PVIs business, is 0.1544/(0.099 + 0.02) - 1 = $0.2975
(recall the formula for the present value of a declining perpetuity). Because this investment is
positive NPV, the firm appropriately makes both maintenance and growth investments.
(10.6)
Residual Income is an estimate of wealth creation by a firm for a particular year from existing
operations. We will show that it is also an annualized measure of NPV when applied to the firm
as a whole. A natural benchmark for residual income is zero. If residual income is positive, the
firm creates wealth for financial asset holders and otherwise not. One does have to be careful
because residual income can be in the millions or even hundreds of millions. What might be a high
value for small firms might be a small amount for large firms. Naturally, other things equal wealth
creation by large firms should be greater than for small firms.
10.6.1
The most general representation of Residual Income is
Residual Income = FFO Maintenance Cap. Exp. WACC Invested Capital
Presuming that CCA is the same as financial statement depreciation, we can ignore adjustments to
Residual Income for deferred income tax. Also, if CCA is the same as per annum maintenance
capital expenditures, then this general representation for Residual Income reduces to the one
commonly used in practice,
71
Residual Income = After Tax NOI WACC Invested Capital
= (1-t)*(EBITDA-deprec) - WACC Invested Capital
where NOI is net operating income.
Because ROIC after tax and after depreciation is after tax NOI divided by invested capital, we can
write the common calculation for Residual Income as
Residual Income = [ROIC (After Tax and Depreciation) WACC] Invested Capital
This calculation illustrates that the primary determinants of Residual Income are the ROIC and
WACC. If a firms ROIC is greater than WACC then Residual Income is positive and vice versa.
If a firm can earn a rate of return (the ROIC) greater than an opportunity cost imposed on capital
(the WACC) it creates wealth for its financial asset-holders, Residual Income is positive. In
addition, we know from our prior analysis and discussion that such a firm also tends to have a
high market to book ratio, a high P/E ratio, and a high share price. When a firm performs well for
its financial asset-holders all of these financial measures tend to reflect this performance.
Let us calculate Residual Income for PVI Company Limited, which we investigated in previous
section of this electronic book. Recall from section 10.5 that PVIs predicted ROIC after tax and
after depreciation is 13.44%, their WACC is 9.9%, and their invested capital is $5,000,000.
Residual Income is, therefore,
Residual Income = [0.1344 - 0.099] 5,000,000 = $177,000
The fact that Residual Income is positive implies that PVI performing well for its financial asset
holders. Operations have more than met the financial market benchmark, and therefore, PVI has
created wealth for its shareholders. These observations are consistent with our analysis and
discussion in section 10.4.
72
10.6.2
From calculations we have done earlier in this chapter, we know that CNRs forward ROIC (after
tax and after depreciation) is 9.36%. Their WACC is 9.9%. Their 2007 year-end invested capital
is $22,553,206. So, CNRs residual income is,
Residual Income = [0.0936 - 0.099] $22,553,206 = -$121,787
Because this number is negative, CNR is not meeting their financial market benchmark for
corporate operating performance.
10.6.3
Notice that in all of the above calculations for Residual Income there is no term for growth. It is
not immediately obvious, but these equations are appropriate for either growing or non-growing
firms. A growth term is not needed because Residual Income is a measure of annualized wealth
creation from existing operations.
At the same time, if a firm has growth opportunities, then the market value of a firms assets
(MVA) should reflect these growth prospects for Residual Income. Consequently, if we discount
future expected Residual Income, we measure, not annualized, but total wealth creation by a firm
for its financial asset-holders.
Let us consider the example of PVI from the previous section of this electronic book once more.
PVIs Residual Income is $177,000. Because of growth, we expect this amount to increase at 4%
per annum. The discounted value of predicted future Residual Income measures total wealth
creation by a firm for its financial asset-holders.
Total Wealth Creation (TWC)
73
= DISCOUNTED VALUE OF PREDICTED FUTURE RESIDUAL INCOME
For a firm with constant growth, like PVI,
EVA1
TWC =
WACC Growth
The term EVA1 is Residual Income predicted in the upcoming year. For PVI Corporation,
EVA1 = $177,000. Hence, for PVI corporation,
177,000
TWC = = $3,000,000
0.099 0.04
Finally, the MVA for a firm is total wealth creation plus the original investment in business
invested capital.
MVA = TWC + IC = $3,000,000 + $5,000,000 = $8,000,000
This calculation is consistent with our determination of the MVA of PVI Corporation from the
previous section of this electronic book. Further, this calculation confirms that Residual Income is
an annualized measure of wealth creation by the firm for its financial asset-holders. The firm
invested $5,000,000 on behalf of its financial asset-holders. Because these assets are now worth
$8,000,000, total wealth creation by the firm for its financial asset-holders is $8,000,000 -
$5,000,000 = $3,000,000. The discounted value of predicted future Residual Income represents
this wealth creation.
The following article, which appeared in the September 20, 1993 issue of Fortune magazine, is an
excellent account of economic value added analysis (Residual Income), and therefore, it is
reproduced in its entirety.
Publisher: Time Inc.
Author: Shawn Tully.
This material has been copied under license from CANCOPY. Fortune
Resale or further copying of this material is strictly prohibited.
74
10.6.4
The primary value of Residual Income in a firm is the promotion of a financial perspective for
planning. In Residual Income, to as great an extent as possible, both a firm and its component
divisions are treated like they were financial investments. The firm, like a financial asset, is
subjected to the rigorous performance criteria of financial markets. A primary benefit of Residual
Income analysis is that it constantly confronts and reminds managers of the discipline of financial
markets. This reminder hopefully focuses the planning effort of managers on the financial
interests of shareholders.
The use of financial standards in Residual Income promotes and highlights the shareholder
perspective in a firm. Residual Income is primarily a measure of wealth creation for shareholders5.
The fundamental components of Residual Income are the rate of return on invested capital (after
tax and after depreciation) and the WACC (which is the financial market benchmark). If a firm
can earn a rate of return greater than WACC, shareholders wealth is incremented. A planning
focus on Residual Income is equivalent to a focus on shareholders wealth, the central theme of
this electronic book.
To earn at least the financial market return, which is the WACC, is a much more demanding
performance criterion than merely to earn positive operating profits. Firms must earn a rate of
return that compensates investors for their interest opportunity cost and for the risk they bear.
These standards require an operating profit which is significantly greater than zero. A firm can
have positive operating profits but yet be performing inadequately relative to a financial market
standard. Residual Income requires that a firms managers face up to the demanding standard
imposed by financial markets.
The exacting nature of the performance criteria imposed on firms by financial markets cannot be
stressed highly enough. The WACC reflects possible rates of return on financial assets of
comparable risk firms. Because other similar firms are your benchmark, it is reasonable to expect
5
For firms in financial distress, NPV is the wealth increment for the composite of all financial asset holders. In
this case, the debt-holders of a firm have a financial asset with equity characteristics.
75
that approximately fifty percent of the firms in the economy have rates of return on invested
capital which exceed the WACC so that they meet their financial market benchmark while the
other fifty percent do not. No firm can operate independently and irrespective of the influence of
financial markets. They either meet this standard or they bear the consequences. The
consequences are falling share prices, disgruntled shareholders, and eventually, one way or the
other, a new managerial team for the firm. The replacement of a set of managers is not immediate
and can take considerable time. In this window of opportunity, Residual Income analysis can help
managers recognize the eminent danger of this displacement so that corrective action can be
taken.
Because Residual Income is a financial perspective on wealth creation, it suggests financial type
remedies for operating problems. Recall that in chapter one, we said that there were three
fundamental questions associated with any investment: (1) risk, (2) the rate of return, and (3) the
required expenditure. The ways to increase Residual Income (and shareholders wealth) are to
increase the rate of return without additional capital, or maintain the existing return with lesser
capital. Because Residual Income analysis explicitly imposes a cost on capital, it encourages its
prudent use. Searching for ingenious ways to economize on capital focuses the planning of
managers on operating improvements.
While Residual Income is a powerful organizational tool for benchmarking and improving the
operating performance of firms, there are a number of caveats to its use.
10.6.5
First, if Residual Income is to be effective in larger firms, it needs to be applied at the level of units
where there is operating control. For example, it makes little sense to impose corporate Residual
Income discipline on small divisions, which have only modest influence on Residual Income at the
firm level. Residual Income must be measured and applied at the level in the firm where operating
efficiencies are sought. Residual Income should identify the wealth increments arising from sets
of operating managers who are responsible for these increments. If this association is made, then
these managers can be rewarded or admonished as appropriate. Applying Residual Income at the
76
level of units in a firm requires internal accounting that is consistent with the principles of
Residual Income and allows managers to measure the amount of capital which they employ.
Managers cannot economize on capital if they dont know how much they are using. This
observation implies that the notion of invested capital is critically important for Residual Income
analysis. See chapter 2 of this electronic book for a discussion of invested capital.
Recall that the WACC is a discount rate for a firms entire set of assets. Because financial market
participants, who assess a firm and its prospects in their entirety, determine the WACC, the WACC
is an opportunity cost for the composite of a firms operating units (and assets). However, these
operating units may themselves have risk differences. It would be improper to impose a
composite opportunity cost on a division that was of significantly greater of lesser risk than the
firm as a whole. The WACC is a good starting point for determining the cost of capital for
operating divisions. You might calculate the WACC and then add or subtract a division specific
increment to reflect greater or lesser risk. Our discussion of the corporate determinants of risk in
chapter 3 of this electronic book should be helpful for you in identifying risk differences between
operating units in your firm.
Second, Residual Income is calculated based on the historical operating results of a firm. This
years Residual Income depends critically on sales for this year. However, the principles of DCF
indicate that wealth and value depend on expected future cash flow rather than realized historical
cash flow. Because of this distinction, dont put undue significant on Residual Income for a single
period. Negative Residual Income for a single period will not tell you much about long-term
operating performance. Residual Income might be negative for a particular quarter because of a
temporary drop in sales. If the level of permanent sales is unaffected, then the decrement to
wealth is not likely significant. On the other hand, if Residual Income is negative for a long
period of time, you probably have a problem to correct. It is important to search out the source
of negative Residual Income before drastic changes in operations are made.
Third, it might not be possible to improve negative Residual Income if it arises from factors
beyond the control of managers. The firm in question might be in a depressed industry. At some
77
time in the past, firms in this industry made positive NPV investments but now the industry is not
as profitable as had been expected and growth has slowed or stopped. Expansion projects are
negative NPV. For the industry as a whole, rates of return on invested capital are lesser than
WACC. Every firm in the industry has negative Residual Income. Investments made in the past
would not currently be made but bygones are bygones the best a firm can do now is operate
existing assets in the most efficient and profitable way as possible. Negative Residual Income, in
this case, does not indicate that managers have destroyed wealth for shareholders. The wealth of
shareholders has diminished but the reason is reduced profitability of the industry rather than the
incompetence of particular managers. Drastic ultimatums like Get Residual Income up to break-
even or be sold, are not likely to be effective in a depressed industry. Managers of firms in this
industry should be rewarded for simply increasing Residual Income: positive Residual Income
may be an unrealistic goal. Nor should firms in this industry be necessarily liquidated. Regardless
of negative Residual Income, firms may nonetheless have consistently positive operating profits
and be able to make interest and other contractual payments. Recall from section 10.2 of this
electronic book that the liquidation decision requires the comparison of the value of a firms assets
in liquidation versus the value of assets operated as a going concern. Even for negative Residual
Income firms, the value of assets operated as a going concern can exceed the value of assets in
liquidation.
The corporate policy implications of negative Residual Income depend upon the reasons for
negative Residual Income. Suppose that a firm is worth more as a going concern than liquidated.
Residual Income need not necessarily be negative because of the lack of managerial skill.
Suppose that this firm is operated in the best possible way by the best possible management. If the
reason for negative Residual Income is the depressed industry in which the firm operates, then
possibly the best thing for the firm to do is to continue to operate with the existing management
and simply work towards increasing Residual Income.
On the other hand, it is possible that the management team of the firm is deficient and that another
management team could operate the firm more effectively, more creatively, or more profitably. In
this case, negative Residual Income is in part attributable to existing managers. If there exists a
firm (or a different management team) that can operate the firm in a better way, then the board of
78
directors should either improve their managerial talent or propose the firm as a takeover
candidate.
Fourth, do not be overly dogmatic about positive Residual Income for start-up and younger firms.
It may be some time from the beginnings of your firm before new technology and new markets are
sufficiently developed and mature that you can reap the benefits of positive Residual Income. If
you religiously close your firm at the first sign of negative Residual Income you might never
achieve the positive Residual Income which you originally anticipated. On the other hand, if
Residual Income is not anticipated to be positive at any time in the future, then you should face up
to the sale/liquidation problem.
To remedy some of the deficiencies of Residual Income, a number of different metrics for
managing and creating shareholder value have been proposed by financial consultants. These
metrics are described in some detail in The Society of Management Accountants Guideline #44
which is entitled Measuring and Managing Shareholder Value Creation. Also, the embedded
article below which appeared in the August 2, 1997 issue of The Economist, reviews and
discusses these metrics in a non-technical way.
Publisher: Economist Newspaper Limited.

This material has been copied under license from CANCOPY.
Resale or further copying of this material is strictly prohibited.
79
(10.7)
The weighted average cost of capital (WACC) is a methodology for using financial market
information to indirectly determine a discount rate for a firms assets. The WACC is a weighted
average of the discount rates for the financial assets of a firm. Because it is a weighted average of
discount rates, the WACC is itself a discount rate: a discount rate for existing assets. The
weighted average cost of capital is a methodology to determine the cost of capital in a restricted
set of applications.
The first application for which the WACC is appropriate is for capital expenditure analysis for
expansion type projects. The WACC is a discount rate for existing assets. The implication of this
observation is that the WACC can be used in DCF to value a firms existing assets. It can also be
used for new ventures if these ventures have the same risk as existing operations.
The second application of the WACC is for corporate performance evaluation. The rate of return
on invested capital after tax and after depreciation is the rate of return that a firm earns for all of
its financial asset holders. One does not know whether this ROIC is high or low unless it is
benchmarked. The WACC is the appropriate benchmark. If the expected ROIC for a firm is
greater than its WACC, then the firm is able to generate returns for its financial asset-holders that
exceed their composite opportunity cost the WACC.
Using the WACC for corporate performance benchmarking is called Residual Income analysis.
This use of the weighted average cost of capital is an important element of long term strategic
planning and value creation for a firm. There are a number of good reference books and articles
on how Residual Income is applied in practice. These references are given below.
80
(10.8)
Ehrbar, Al. Residual Income: The Real Key to Creating Wealth, John Wiley & Sons, Toronto,
New York, 1998.
Clark, Peter J. and Stephen Neill. The Value Mandate, American Management Association, New
York, 2001.
Copeland, Thomas, T. Koller, and J. Murrin. Valuation: Measuring and Managing the Value of
Companies, John Wiley Publishers, Toronto, New York, 1990.
Grant, James I. and James A. Abate. Focus on Value: A Corporate and Investor Guide to Wealth
Creation, John Wiley Publishers, New York, 2001.
John Scully, The Real Key to Creating Wealth, Fortune, September 20, 1993.
The Society of Management Accountants of Canada, Management Accounting Guideline #44:

Measuring and Managing Shareholder Value Creation, 1997.
Valuing Companies: A Star to Sail By? The Economist, August 2, 1997.
81
(10.9)
1. WACC.
The market value of ABCs equity is 50 million dollars. The market value of their bonds is
also 50 million dollars. The yield to maturity on ABCs bonds is 8% per annum. The
corporate tax rate is 40%. ABC is a non-growing firm, and dividends (for all shareholders)
are expected to be $5,000,000 per annum.
What is the weighted average cost of capital for ABC? What is the market capitalization rate
for equity?
Solution
2. WACC and Capital Market Efficiency.

ABC has announced to financial markets that it plans to expand operations. This expansion
will yield $200 in incremental EBITDA per annum into the indefinite future and requires an
initial investment of $1,000. The corporate tax rate is 50%. The firms WACC is 8 percent
per annum. EBITDA is currently (before the new venture) $600 per annum (expected
indefinitely). The market capitalization rate for equity is 12 percent. The yield on ABCs
bonds is 8 percent.
What are the market values for ABCs bonds and common equity?
Solution
3. WACC and Performance Evaluation.

ABC is a non-growing firm, it retains no earnings, and it pays all residual cash flows after
interest to shareholders as dividends. ABC is financed with common shares and long-term
bonds. The bonds are of sufficiently long term that they can be represented as a perpetuity of
annual coupon payments for the purpose of valuation. ABCs trade capital is composed of
inventory plus accounts receivable less accounts payable.
ABC sells widgets. Projected sales are 1,000,000 units per annum into the indefinite future.
Product price is $2.8 per unit and variable production costs are $2.1 per unit. Fixed expenses
are $100,000 per annum. ABC holds accounts receivable equal to 40% of per annum dollar
sales (before tax) and inventory equal to 15% of per annum dollar sales (before tax).
Accounts payable equal 10% of per annum variable expenses plus 25% of per annum fixed
expenses (both before tax). ABCs expenditure into plant and property assets is $2,225,000.
Ignore CCA in this problem. ABC has financed its operations (in part) with $1,000,000 (par-
value) 12% coupon rate bonds long-term bonds (paid annually). The yield to maturity on
bonds of equivalent risk to those of ABC is 10% per annum (also paid annually). The market
capitalization rate on ABCs equity is 11% per annum. ABC anticipates no additional future
investments for replacement of existing assets or for growth). ABC pays all residual cash
flows from asset operations after interest payments to shareholders as dividends, and
therefore, ABC is a non-growing firm. Corporate taxes are 40%. There are 1,000,000 shares
of ABC, which is currently traded on the Harbor Center Stock Exchange.
a) Find the rate of return on equity for ABC.
82
b) Compare ABCs rate of return on equity to its market capitalization rate for shares. Does
the fact that the rate of return on equity is greater than the market capitalization rate on
equity imply that an investor should purchase a share in ABC? Explain.
c) Find ABCs after-tax rate of return on invested capital.
d) Find the current share price for ABC.
e) Find the weighted average cost of capital for ABC.
Solution
4. WACC and a Non-Growing Firm.

ABC is a non-growing firm: it retains no earnings and pays all residual cash flow after interest
payments and corporate tax to shareholders as dividends. ABC is financed with common
shares and long-term bonds. The bonds are of sufficiently long-term that they can be
represented as a perpetuity of annual coupon payments for the purpose of valuation. ABCs
trade capital is composed of inventory, accounts receivable, less accounts payable. Coupons
and dividends are paid annually. The next and upcoming coupon and dividend payment is in
exactly one year.
The following financial characteristics are known of ABC:
Because ABC is a non-growing firm, the expected rate of return on the purchase of a share
is the dividend yield, which is 12.5% per annum.
The debt to equity ratio (based on market rather than accounting numbers) is 1/3.6.
the corporate tax rate is 40%.
the ratio of the total market value of ABCs equity to the book value of equity (all equity
accounts) is 3.0,
the par value of bonds is 200 million,
invested capital turnover (sales divided by invested capital) = 0.8,
gross profit margin = 32.5%,
inventory turnover (calculated with cost of goods sold) = 1.4,
accounts receivable turnover = 4.0,
ratio of trade capital to invested capital = 0.3,
the yield on ABCs bonds is 8 percent per annum,
the coupon rate on ABCs debt is 10% per annum.
Determine the following for ABC:
a) the rate of return on invested capital,
b) invested capital,
c) trade capital,
d) book value of equity (all equity accounts),
e) current ratio,
f) net profit margin,
g) the weighted average cost of capital.
Solution
83
5. WACC and a Growing Firm.

ABC is a growing firm. They have a payout ratio of 88.98072% and a predicted rate of return
on equity into the indefinite future of 18.15% percent per annum. ABC has financed it
operations with long-term debt (bonds) and common shares. Coupons and dividends are paid
annually. The next and upcoming coupon and dividend payments are in exactly one year.
ABCs. Total earnings in one year are predicted to be $363,000. The bonds are of sufficiently
long-term that they can be represented as a perpetuity of annual coupon payments for the
purpose of valuation. The coupon rate equals the yield on ABCs bonds, 10 percent per
annum. Par value is $1,000,000. Economic depreciation and capital cost allowance relative
to invested capital is 1.5% per annum. Maintenance capital expenditures are positive NPV
investments, and therefore, they are under-taken each year. ABCs invested capital is
$3,000,000. The corporate tax rate is 40%. The market capitalization rate on equity is 12%
per annum.
(a) Find ABCs weighted average cost of capital.
(b) Find predicted free cash flow for the upcoming year.
(c) Find ABCs predicted Residual Income for the upcoming year.
h) the weighted average cost of capital.
Solution
6. WACC for a Private Non-growing Firm.

ABC is a private non-growing firm. It retains no earnings for the purpose of growth. ABCs
predicted per annum free cash flow is $1,250,000. An estimate of the market value of ABCs
debt is $4,000,000. A financial market opportunity cost for ABCs debt is about 8% per
annum. ABCs tax rate is 40%. The opportunity cost of ABCs equity is 12%.
Required: Find ABCs market value of assets (MVA) and WACC.
Solution
7. WACC for a Private Growing Firm.

ABC is a private growing firm. Per annum growth investments, at year-end, are 3% of invested
capital as of the beginning of the year. ABC makes maintenance capital expenditures to offset the
effect of economic depreciation, and these maintenance capital expenditures equal per annum
capital cost allowances, which also equal ABCs per annum financial statement depreciation.
Predicted free cash flow in the upcoming year is $1,250,000. An estimate of the market value of
ABCs debt is $4,000,000. A financial market opportunity cost for ABCs debt is about 8% per
annum. ABCs tax rate is 40%. The opportunity cost of ABCs equity is 12%.
Required: Jointly determine ABCs market value of assets (MVA) and WACC.
Solution
84
(10.10)
1. WACC.
Because ABC is a non-growing firm, the market capitalization rate on equity is
5,000,000/50,000,000 = 10%.
The WACC, is therefore, = 0.6*0.08*0.5 + 0.1*0.5 = 7.4%.
2. WACC and Capital Market Efficiency.

The market value of ABCs assets is 800*0.5/0.08 - 1,000 = $4,000.
The $800 arises from existing operations ($600) and projections for the new operations($200).
The $1000 is the required investment for the new venture. The discount rate is the same for the
new and existing operations because they are presumed to be of approximately the same risk.
Let B be the market value of bonds and let E be the market value of equity.
Then, $4,000 = B + E.
In addition, 0.08 = 0.08*0.5*B/4000 + 0.12*E/4000.
If you solve these two equations, you will find that B = $2,000, E = 2,000.
3. WACC and Performance Evaluation.

(a) Sales = 2.8*1,000,000 = $2,800,000
Variable costs = $2.1*1,000,000 = $2,100,000
Fixed costs = 100,000
EBITDA = (2.8-2.1)*1,000,000-100,000
Accs Rec. = .40*2,800,000 = 1,120,000
Inventory = 0.15*2,800,000 = 420,000
PPE = 2,225,000
Accs payable = 0.10*2,100,000 = $210,000+25,000 = $235,000
ROE = dividends/(book-value of equity) = 0.6*(CM/$*1,000,000-FC-interest)/2,530,000
= 0.6*(700,000-100,000-120,000)/2,530,000 = 11.38%.
(b) ROE = 11.38% is greater than the market capitalization rate (given) of 11% per annum. This
does not imply that an investor should necessarily purchase a common share. If markets are
informationally efficient the information that the firm earns a high rate of return for its
shareholders is already reflected in price. In this case, by the time that you buy a share at a higher
price, the rate of return you receive will be no greater or lesser than the market capitalization rate
(11%).
(c) Invested capital is Accs. Rec. + Inventory - Accs. Payable + PPE = 1,120,000 + 420,000 -
235,000 +2,225,000 = 3,530,000
The rate of return on invested capital is EBITDA*(1-tax rate)/Invested capital
= 0.6*600,000/3,530,000 = 10.198%
(d) The market value of equity is dividends discounted at 11% is 0.6*(600,000-120,000)/0.11
= 2,618,181.8 The share-price is therefore 2,618,181.8/1,000,000 = $2.62.
(e) The market value of bonds is 0.12*1000000/0.10 = $1,200,000
0.6 * 0.10 * 1,200,000 2,618,181.8
0.11 *
The WACC = 1,200 ,000 2 ,618,181.8 1,200,000 2,618,181.8 = 9.428%
4. WACC and a Non-Growing Firm.

The book value of bonds is 200 million. Therefore, the market value of bonds is
85
0.1*200,000/0.08 = 250,000. Using the debt to equity ratio (in market value terms), 250,000/
(market value of equity) = 1/3.6: solving this equation you find that the market value of equity is
900,000.
Therefore, the market value of assets, equity, and debt respectively is: $1,150, $250, $900.
The market capitalization rate for equity is 12.5% per annum (the dividend yield) because
expected capital gain is zero. Using the zero growth version of the DDM and the knowledge that
the market value of equity is 900, you can find that predicted EBITDA is $207.5:
0.6( EBITDA 0.1 * 200)
900 = 0.125 .
Because the market to book ratio for equity is 3.0 = 900,000/book equity, book equity is 300,000.
The book values of assets, equity, and debt, respectively are: $500, $300, and $200 (in
millions).
The ROIC is 0.6*207.5/500 = 24.9%.
Invested capital is 500.
Trade capital is 0.3*500 = $150.
Book value of equity is $300.
Because IC turnover is 0.8, predicted sales are 0.8*500 = $400. Cost of goods sold, therefore, is
0.675*400 = $270. Using inventory turnover, you can find that inventory is 270/1.4 = $192.86.
Using accounts receivable turnover, you can find that accounts receivable are 400/4 = 100.
Because trade capital is 150, accounts payable are $192.86+100-150 = 142.86. The current
ratio is, therefore, (192.86+100)/142.86 = 2.05.
Net income is 0.6(207.5-0.1*200) = 112.5. Therefore, net profit margin is 112.5/400 =
28.125%.
WACC is (1-0.4)*0.08*(250/1150)+0.125*900/1150.
5. WACC and a Growing Firm.

If you multiple the retention ratio and the ROE, you find that predicted growth is 2% per annum.
Because depreciation is 0.015*3,000,000 and interest is 100,000, predicted EBITDA is
$750,000: 363,000 = 0.6*(EBITDA-45,000-0.1*1,000,000)
Cashflow from operations is 0.6*750,000+0.4*45,000 = $468,000.
Free cashflow is 468,000 45,000 0.02*3,000,000 = 363,000.
Dividends are 0.8898072*363,000 = 323,000.
The market value of equity is 323,000/(.12-0.02) = 3,230,000.
The market value of assets is 1,000,000 + 3,230,000 = 4,230,000.
The WACC is = 0.6*0.1*1,000,000/4,230,000 + 0.12*3,230,000/4,230,000 = 10.58156%.
ROIC after tax and after depreciation is = 0.6*(750,000-45,000)3,000,000 = 14.1%.
Predicted EVA for the upcoming year is 0.141*3,000,000 - 0.1058156*3,000,000 =
$105,553.2.
6. WACC for a Private Non-growing Firm.

Let, MVA be market value of assets. Then, because ABC is a non-growing firm,
1, 250, 000
a) MVA =
WACC
4, 000, 000 MVA 4, 000, 000
b) WACC = 0.6 * 0.08 * 0.12 *
MVA MVA
c) Substitute b) into a) and solve to find that MVA = $12,816,667 and WACC =
9.7529%.
86
7. WACC for a Private Growing Firm.

Let, MVA be market value of assets. Then, because ABC is a non-growing firm,
1, 250, 000
a) MVA =
WACC 0.03
4, 000, 000 MVA 4, 000, 000
b) WACC = 0.6 * 0.08 * 0.12 *
MVA MVA
c) Substitute b) into a) and solve to find that MVA = $17,088,888 and WACC = 10.3147.
87
(10.11)
asset valuation, 552 market to book ratio, 548

Canadian National Railway, 540 market value of debt, 537
capital cost allowance, 552 market value of equity, 537
capital expenditure, 552 market value weights, 537
constant growth expected return, 542 performance evaluation, 548
corporate performance, 535 price to forward earnings ratio, 542
cost of capital, 534 private firm, 554
dividend yield, 542 public firm, 538
economic depreciation, 556 Rate of Return on Equity, 541
enterprise value, 543 rate of return on invested capital, 541, 556
expansion, 535, 547 residual income, 534, 561, 563, 567
free cash flow, 557 total wealth creation, 564
maintenance capital expenditures, 552,553 weighted average cost of capital
market cap, 543 cost of capital, 534
market capitalization rate, 537
88

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Weighted Average Cost of Capital & Corporate Performance Evaluation

Introduction to Corporate Financial Analysis

Chapter Ten Contents

The WACC then, in this case, is calculated as:

after tax discount rate on discount rate

The WACC is,

(10.4) for a Public Firm

Exhibit 10-1: Market Value Balance Sheet for ABC Ltd.

L.T. Debt = $2,000,000

The weighted average cost of capital for ABC is:

WACC = (1 0.40) 0.06 0.25 + 0.12 0.75 = 9.9%

Invested Capital Operating 31-Dec-07 31-Dec-06 31-Dec-05

Invested Capital Financial

We now have all of the variables required to calculate CNRs WACC,

12,178, 772 17, 090, 000

- Predicted EBITDA in the upcoming year is $1,220,000,

Trade Capital = $1,000,000 L.T. Debt (Par value) = $2,000,000

Net Fixed Assets = $4,000,000 Common Equity = $3,000,000.

In the upcoming year, financial statement depreciation is 0.025*4,000,000 = $100,000.

ROIC after tax and after depreciation =

( EBITDA deprec) * (1 tax rate) (1,220,000-100,000)*(1-0.4)

DEBT 12,178, 772

Forward ROIC (1 0.02025) *0.032*0.54 0.1736*0.46 =9.36%

market value of assets $8,000,000

Net Income (1-tax rate)*(EBITDA-deprec.-interest)

0.6 * (1, 220,000 -100,000-0.06*2,000,000)

First, let us find net income (NI):

NI = (1-tax rate)*(EBITDA-deprec.-interest) = 0.6*(1,220,000 - 100,000-120,000) = $600,000.

RE = Retained Earnings = g*BVE = 0.04*3,000,000 = $120,000.

Expected Dividends $480,000

market value of equity $6,000,000

Free Cash flow = Funds from operations

In our example, this amount can be calculated as

FCF = (1 t ) * ( EBITDA CCA) CCA TC Cap. Exp.

t is the corporate tax rate,

FCF = 0.6*($1,220,000 100,000) + $100,000 $300,000 = $472,000.

Exhibit 10-3: Invested Capital Balance Sheet for PVI Ltd.

Trade Capital = $1,000,000 L.T. Debt (Par value) = $2,000,000

Net Fixed Assets = $4,000,000 Common Equity = $3,000,000.

Invested Capital = $5,000,000 Invested Capital = $5,000,000

Free Cash flow = Funds from operations

In our example, this amount can be calculated as

FCF = (1 t ) * ( EBITDA CCA) CCA TC Cap. Exp.

t is the corporate tax rate,

FCF = 0.6*($1,220,000 100,000) + 100,000 $300,000 = 472,000.

Because FCF1 is $472,000, and projected growth is 4% per annum,

second equation defines WACC:

t is the corporate tax rate,

Because MVA = MVD + MVE,

MVD (MVA - MVD)

Residual Income = FFO Maintenance Cap. Exp. WACC Invested Capital

Residual Income = After Tax NOI WACC Invested Capital

= (1-t)*(EBITDA-deprec) - WACC Invested Capital

where NOI is net operating income.

Residual Income = [0.1344 - 0.099] 5,000,000 = $177,000

Residual Income = [0.0936 - 0.099] $22,553,206 = -$121,787

Total Wealth Creation (TWC)

= DISCOUNTED VALUE OF PREDICTED FUTURE RESIDUAL INCOME

For a firm with constant growth, like PVI,

MVA = TWC + IC = $3,000,000 + $5,000,000 = $8,000,000

Publisher: Economist Newspaper Limited.

The Society of Management Accountants of Canada, Management Accounting Guideline #44:

Valuing Companies: A Star to Sail By? The Economist, August 2, 1997.

Forward ROIC (1 0.02025) 0.0320.54 0.1736*0.46 =9.36%

NI = (1-tax rate)(EBITDA-deprec.-interest) = 0.6(1,220,000 - 100,000-120,000) = $600,000.

RE = Retained Earnings = gBVE = 0.043,000,000 = $120,000.