Weighted average cost of capital

Overview

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital. Importantly, it is dictated by the external market and not by management. The WACC represents the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere. Companies raise money from a number of sources: common stock, preferred stock and related rights, debt, convertible debt, and so on. The WACC is calculated taking into account the relative weights of each component of the capital structure. Companies can use WACC to see if the investment projects available to them are worthwhile to undertake.

Calculation

In general, the WACC is calculated with the following formula:

WACC

=

∑

i = 1

N

r

i

⋅ M

V

i

∑

i = 1

N

M

V

i

{\displaystyle {\text{WACC}}={\frac {\sum _{i=1}^{N}r_{i}\cdot MV_{i}}{\sum _{i=1}^{N}MV_{i}}}}

where

N

Tax effects

Tax effects can be incorporated into this formula. For example, the WACC for a company financed by one type of shares with the total market value of

M

V

e

{\displaystyle MV_{e}}

and cost of equity

R

e

{\displaystyle R_{e}}

and one type of bonds with the total market value of

M

V

d

{\displaystyle MV_{d}}

and cost of debt

R

d

{\displaystyle R_{d}}

, in a country with corporate tax rate

t

Debt

The firm's debt component is stated as kd, and since there is a tax benefit from interest payments, the after-tax WACC component is kd(1-T), where T is the tax rate. Increasing the debt component under WACC has advantages including:

no loss of control (voting rights), interest expense is tax deductible. But there are also disadvantages including:

legal obligation to make payments, taking on more debt increases financial risk.

Equity

The weighted average cost of capital equation including preferred stock is:

WACC

=

w

d

⋅ [

K

d

( 1 − t ) ] +

w

p f

⋅

K

p f

+

w

c e

⋅

K

c e

Marginal cost of capital schedule

Marginal cost of capital (MCC) schedule or an investment opportunity curve is a graph that relates the firm's weighted cost of each unit of capital to the total amount of new capital raised. The first step in preparing the MCC schedule is to rank the projects using internal rate of return (IRR). The higher the IRR the better off a project is.

Enterprise valuation (WACC approach)

The WACC approach is the most widely used variant of the discounted cash flow (DCF) method. Under this "entity approach," the firm is conceptually separated into an operating area (Operating Free Cash Flow) and a financing area. Assuming an infinite corporate lifespan, the market value of the enterprise—including the market value of non-operating assets

N

0

{\displaystyle N_{0}}

—is determined by the following formula:

Enterprise Value

=

∑

t = 1

∞

O F C

F

t

( 1 + W A C

C

t

)

t

+

N

External links

Frank, Murray; Shen, Tao (2016). "Investment and the Weighted Average Cost of Capital". Journal of Financial Economics. 119 (2): 300–315. doi:10.1016/j.jfineco.2015.09.001. SSRN 2014367. Velez-Pareja, Ignacio; Tham, Joseph (August 7, 2005). "A Note on the Weighted Average Cost of Capital WACC: Market Value Calculation and the Solution of Circularity between Value and the Weighted Average Cost of Capital WACC". SSRN 254587. Cheremushkin, Sergei Vasilievich (December 21, 2009). "How to Avoid Mistakes in Valuation – Comment to 'Consistency in Valuation: A Practical Guide' by Velez-Pareja and Burbano-Perez and Some Pedagogical Notes on Valuation and Costs of Capital". SSRN 1526681.