WACC for HP
Posted by Sabrina Warren on Feb272023
Weighted average cost of capital is an important measure used by firms to make capital budgeting decisions and by investors to make judgments about stock valuation and invest accordingly (Moore, 2016).
WACC of HP is calculated for firms that include both equity and longterm debt in their capital structure. Firms can use WACC to ascertain the optimal capital structure and choose between projects based on the return they will generate (Wecker & Reilly, 2009).
On the other hand, IRR for HP is the discount rate at which investment breaks even and is the rate at which the present value of all future cash inflows is equal to the initial investment in the project (Reniers, Talarico, & Paltrinieri, 2016).
Overview of WACC
WACC is the hurdle rate used to find the NPV of a business or an investment project by discounting the future cash flows and terminal value of the firm or project (Visconti, 2021). 'It finds the cost of each part of the firm's capital structure by weighing debt and equity in the firm's capital structure' (CFI Team, 2022).
Introduction to WACC model
The weighted average cost of capital is the opportunity cost of capital for a firm as it is the rate of return a company expects from an investment. The cost of debt and equity are weighted by their proportion of debt and equity to get this discount rate.
The greater a company's sources of financing, the more complex are WACC calculations. WACC is an essential part of DCF analysis, and it shows the relationship between the components of the capital of a firm, in particular debt and equity (Dikov D., 2020).
Application of the WACC model
The application of WACC to a firm's capital budgeting decision is explained by taking an example of the public limited HP that is making an investment and capital allocation decision. The capital structure of the firm is taken along with the cost of capital and cost of debt for HP to find its WACC.
Assumptions
The WACC model assumes that additional debt is taken upon by the company within the context of capitalization. It is assumed that one form of financing replaces another, such as bonds replacing equity shares, while the total capital of the firm remains constant (Karagiannidis, Berry, & Betterton, 2014). Thus it is assumed that HP replaces any additional debt it takes upon with a reduction in its shares issued.
WACC Formula
WACC = Re (+Rd (1t) ( (Dikov D. , 2020)
Where:
Re = Cost of Equity
Rd = Cost of Debt
E = Total Market Value of Equity
D = Total Market Value of Debt
V = Total value of Company i.e., Equity + Debt value
T = Tax Rate applicable on the company
Capital Structure
The calculation of WACC takes into account the target capital structure that has a weightage of both debt and equity. 'Most firms finance their assets and projects using both debt and equity. The target capital structure is the mix of preferred stock, common stock, and longterm debt that a company is striving to achieve that will maximize its share price.'
Most firms finance their assets and projects using both debt and equity. For HP, the amount of debt and equity it will take upon for new investments is considered to find its target debt structure. Maximum financial performance in a company results when the financial structure is minimal while WACC is maximum (BărbuţăMişu & Valentina, 2017).
Equity shares provide a firm with greater financial flexibility; however, it has a higher cost of capital. On the other hand, debt, although it obligates a company to fixed future payments, is a comparatively cheaper form of capital (CFA Institute, 2022).
The target capital structure of HP is shown below:
Target Capital Structure 

Debt to Total Capital 
31% 
Equity to Total Capital 
69% 
Debt to Equity Ratio 
44.9% 
Market value of debt
The book value of debt in financial statements is different from the market value of debt that is used in WACC calculation. Market value of debt is the price investors are willing to pay to buy a company's debt (Corporate Finance Institute Team, 2022).
A company's debt can be both traded in the market or nontraded. An analyst finds the market value of debt by taking coupon payments equal to interest expense on entire debt and taking a weighted average maturity of all debt (Corporate Finance Institute Team, 2022).
Market value of equity
'The market value of equity, also represented by market capitalization, is found by multiplying the outstanding shares of a company with the current market price of those shares. The market price of shares is the price investors are currently willing to pay to buy shares in the stock market.'
HP has 10,000 outstanding shares, and these shares are currently traded in the stock market at the US $23 per share. The market value of HP's total equity capital would therefore be $230,000 (Total outstanding shares of the Company HP * Market price of each share at current date)
Cost of equity
Cost of equity capital for a firm can be found using either CAPM or the dividend discount model. The cost of equity is the most troublesome component of WACC as it often gives a subjective with a number of shortcomings (Moore, 2016).
Cost of equity can be found using Dividend Discount model through the following formula:
Rs = D1+ g
Po
Where
Rs= The company's cost of equity capital
D1 = Dividend per share expected over next year
Po = Current stock price
g = sustainable growth rate for the company (Cost of Equity, 2022)
The CAPM model is based on two key assumptions: that security markets are efficient and competitive and that security markets primarily consist of rational, risk averse investors (Mullins, 2022).
Cost of equity can be found using CAPM through the following formula:
Rs= Rf+ βs(Rm– Rf)
Where
Rs= The company's cost of equity capital
Rf= The riskfree rate
Rm= The expected return on the stock market as a whole
βs= The stock's beta (Mullins, 2022)
The riskfree rate is the return an investor can expect to earn on a security with zero risk. It is mostly the rate of 10year government bonds and securities and is adjusted for inflation (Vaidya & Thakur, 2022). Since HP operates in the USA, the 10year Treasury rate for US government bonds is taken, which is 2.81% (YCharts, 2022).
The market risk premium is calculated as the difference between stock market return and riskfree rate. Past performance of market and company is analyzed to find a market risk premium of 5.3% for HP.
Beta measures the total systematic risk inherent in the entire financial market and is undiversifiable (Analystprep, 2020). It is found by comparing a public company's returns over time to the returns of a stock market. The levered beta for HP is 1.67.
The cost of equity using CAPM model for HP is calculated as follows:
Cost of Equity 

Riskfree rate 
2.81% 
Market risk premium 
5.3% 
Levered Beta 
1.67 
Cost of Equity 
11.66% 
Cost of debt
'Cost of debt used in calculating WACC is the least rate of return a debt holder is willing to accept in exchange for bearing risk. Cost of debt is theeffective interest ratethat a company pays on its current liabilities to its debt holders and creditors (Thakur, 2022).'
Calculating the cost of debt for a company is an easier and less subjective process than the cost of equity. The average yield to maturity for all outstanding debt can be taken, while for private companies, credit rating can be used and a suitable spread added to it
Debt of HP includes both longterm and shortterm interestbearing debt, which includes bonds, bank loans, and mortgage payments. An average of the yield to maturity of all outstanding debt can be taken.
The cost of debt can also be found by using the following formula:
Rd = Rf + Debt risk premium
Where
Rd = cost of debt of the firm
Rf = Riskfree rate
Debt risk premium = Risk of a firm defaulting
Since interest expenses are deductible and lead to tax savings the aftertax cost of debt is used in calculating WACC. The tax rate applicable on HP is 37%. The aftertax cost of debt is 4.66 (7.4*(10.37)).
Cost of Debt 

Cost of Debt 
7.4% 
Taxes 
37.0% 
After Tax Cost of Debt 
4.66% 
WACC Calculation for HP
The final WACC calculation for HP is shown below:
WACC Calculation 

Target Capital Structure 

Debt to Total Capitalization 
31% 
Equity to Total Capitalization 
69% 
Debt to Equity Ratio 
44.9% 


Cost of Equity 

Riskfree rate 
2.81% 
Market risk premium 
5.3% 
Levered Beta 
1.67 
Cost of Equity 
11.66% 


Cost of Debt 

Cost of Debt 
7.4% 
Taxes 
37% 
After Tax Cost of Debt 
4.66% 


WACC 
9.49% 
The WACC is found by multiplying the cost of debt and equity by the relevant market weight and adding together the products. The WACC for HP is 9.49 (8.05 + 1.45).
IRR for HP
IRR is used by investors and managers for investment and capital budgeting decisions. When making a capital budgeting or investment decision, firms calculate the NPV or IRR to determine if the initial investment will be recovered by subsequent cash inflows and will the project result in a positive return.
In calculating both the NPV and IRR for investment, cash flows relevant to the project are used, and both uses discounted cash flow analysis to find the worth of future cash flows at the present date by taking into account the time value of money (Reniers, Talarico, & Paltrinieri, 2016).
Calculating IRR
IRR is the discount rate at which NPV is zero and hence can be calculated by a formula. However, because of the nature of the formula, the trial and error method or programmed software is used to calculate IRR (CFI, 2022).
IRR Formula
The following formula is used to find IRR where NPV is kept zero:
(Fernando, 2022)
Where
Ct = Netcashinflowduringtheperiod
Co = Totalinitialinvestmentcosts
IRR = Theinternalrateofreturn
t = Thenumberoftimeperiods
Accept/Reject criteria for projects
'The greater the IRR of a project, the higher will be the return generated from the project. Once IRR is calculated it is compared to the cost of capital of the firm. An investment is accepted if IRR is greater than that project's cost of capital. However, if IRR of a project is found to be lower than the cost of capital of the firm, the project is rejected. This is because, at a discount rate above the IRR, the project generates a positive return while below the IRR rate the return is negative as financing investment is not recovered.'
Comparison with NPV method
Both the NPV and IRR can be calculated to rank financial projects in order to aid management in making investment decisions with the limited capital they have on hand. While NPV discounts all future cash flows using WACC to find the present value of project at the present date, the IRR method calculates the discount rate needed to make project break even (Green, 2021).
NPV uses WACC, which is the discount rate relevant to the specific company, while IRR compares the rate of a particular project to the discount rates of other investments (Green, 2021). Both these methods are used by managers and investors to determine the profitability of an investment. Often IRR approach is preferred because a percentage measure is easier to comprehend. The methods are often used in combination to allow for greater reliability.
Criticisms of IRR
There are certain flaws in the IRR approach. Multiple and complex IRR's can arise. The IRR decision might not be consistent with the NPV decision, and IRR criteria may not be applicable on variable costs of capital (Magni, 2010).
IRR can also be misleading in its portrayal of returns, such as by being artificially inflated during short terms and hence cannot be relied on to make an investment decision.
Additionally, internal rate of return calculation is based on the assumption that all cash flows of a project will be reinvested at the same rate as the project and not at thecompany's cost of capital.Thus, IRR may not be an accurate representation of the profitability of a project.
IRR Calculation for HP
HP is deciding between two projects to build a new manufacturing unit at location X and Y. The initial investment required at both looks and the subsequent cash flows are different. The finance manager at HP wants to calculate the IRR to find if both projects should be accepted or rejected.
The cash flows for building manufacturing unity at Location X are as follows:
Year 
Cash Flow 
0 
67000 
1 
11260 
2 
18220 
3 
15950 
4 
17430 
5 
18200 
The initial cash flow is negative since investment is required by HP to build the manufacturing unit. From year 1 the cash flows are positive as cash begins to flow in from the production taking place at the unit.
The IRR is found to be 6.33% by trial and error and inbuilt formula in Ms. Excel. At 6.33% discount rate the Net Present Value of this project is zero.
The project of building a manufacturing unit at Location X is rejected since IRR of this project is lower than the WACC of the firm (6.3% < 9.49%). This signifies that project will not generate positive return and hence is not feasible or profitable for HP.
The cash flows for manufacturing unity at Location Y are as follows:
Year 
Cash Flow 
0 
74600 
1 
18220 
2 
18700 
3 
19500 
4 
19870 
5 
22650 
This project requires a great outlay in investment that project at Location X; however, the predicted cash flows of this project are also greater than the project at Location X.
The IRR of project at Location Y is found to be 9.85% using these cash flows and by keeping Net Present Value of the project equal to zero.
The project of building manufacturing unit at Location Y is accepted since the IRR of this project is greater than the WACC of the firm (9.85% > 9.49%). This means that the project at Location Y will recover its initial financing cost of investment and will generate a positive return for HP.
Thus the finance department at HP will give the goahead for the project of building a manufacturing facility at Location Y since it is financially feasible for the company.
Conclusion
IRR analysis has thus been used by HP to compare both projects that had a difference in scope and cash flows. It enabled the finance department at HP to choose the project that would generate the highest return and reject those projects that are unable to recover the initial investment. The WACC of HP plays an important role in this analysis as investing decision is made after comparing IRR with WACC. This analysis can be combined with NPV calculation to better support the investment decision.
Bibliography
Analystprep. (2020, December 15). Beta and CAPM. Retrieved from Analyst Prep: https://analystprep.com/blog/betaandcapm/
BărbuţăMişu, N., & Valentina, E. (2017). Influences of the Capital Structure and the Cost of Capital on Financial Performance. Risk in Contemporary Economy .
CFA Institute. (2022). Capital Structure Level I. Retrieved from CFA Institute: https://www.cfainstitute.org/en/membership/professionaldevelopment/refresherreadings/capitalstructure
CFI Team. (2022, January 23). WACC. Retrieved from Corporate Finance Institute: https://corporatefinanceinstitute.com/resources/knowledge/finance/whatiswaccformula/
Corporate Finance Institute Team. (2022, February 8). Market Value of Debt. Retrieved from Corporate Finance Institute: https://corporatefinanceinstitute.com/resources/knowledge/finance/marketvalueofdebt/
Cost of Equity. (2022). Retrieved from Xplaind: https://xplaind.com/832766/costofequity
Dikov, D. (2020, 02 21). Understanding the Weighted Average Cost of Capital (WACC). Retrieved from Medium: https://medium.com/magnimetrics/understandingtheweightedaveragecostofcapitalwacc948182d97e6
Dikov, D. (2020, February 21). Understanding the Weighted Average Cost of Capital (WACC). Retrieved from Medium: https://medium.com/magnimetrics/understandingtheweightedaveragecostofcapitalwacc948182d97e6
CFI. (2022, April 28). Corporate Finance Institute. Retrieved from Corporate Finance Institute: https://corporatefinanceinstitute.com/resources/knowledge/finance/internalratereturnirr/
Green, J. (2021, November 18). Net Present Value vs. Internal Rate of Return. Retrieved from The Balance: https://www.thebalance.com/npvvsirraninvestorsguide5190894
Karagiannidis, I., Berry, S., & Betterton, C. (2014). Understanding Weighted Average Cost of Capital: A Pedagogical Application. Journal of Financial Education .
Kierulff, H. (2012). IRR: A Blind Guide. American Journal Of Business Education , 417425.
Magni, C. (2010). Average Internal Rate of Return and Investment Decisions: A New Perspective. The Engineering Economist .
Moore, D. (2016). A look at the actual cost of capital of US firms. Cogent Economics and Finance .
Mullins, D. (2022). Does the Capital Asset Pricing Model Work? Harvard Business Review .
Reniers, G., Talarico, L., & Paltrinieri, N. (2016). CostBenefit Analysis of Safety Measures. Dynamic Risk Analysis in the Chemical and Petroleum Industry , 195205.
Thakur, M. (2022). Cost of Debt Formula. Retrieved from Finance: https://www.educba.com/costofdebtformula/
Vaidya, D., & Thakur, M. (2022). Risk Free Rate Formula. Retrieved from WallStreet mojo: https://www.wallstreetmojo.com/riskfreerateformula/
Visconti, R. (2021). DCF Metrics and the Cost of Capital: ESG Drivers and Sustainability Patterns. 18.
Wecker, W., & Reilly, R. (2009). On the Weighted Average Cost of Capital. Journal of Financial and Quantitative Analysis , 123126.
YCharts. (2022, July 7). 10 Year Treasury Rate. Retrieved from YCharts: https://ycharts.com/indicators/10_year_treasury_rate
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