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.^{ [1] }

- Calculation
- Tax effects
- Components
- Debt
- Equity
- Marginal cost of capital schedule
- See also
- References
- External links

Companies raise money from a number of sources: common stock, preferred stock, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, and so on. Different securities, which represent different sources of finance, are expected to generate different returns. The WACC is calculated taking into account the relative weights of each component of the capital structure. The more complex the company's capital structure, the more laborious it is to calculate the WACC.

Companies can use WACC to see if the investment projects available to them are worthwhile to undertake.^{ [2] }

In general, the WACC can be calculated with the following formula:^{ [3] }

where is the number of sources of capital (securities, types of liabilities); is the required rate of return for security ; and is the market value of all outstanding securities .

In the case where the company is financed with only equity and debt, the average cost of capital is computed as follows:

where is the total debt, is the total shareholder's equity, is the cost of debt, and is the cost of equity. The market values of debt and equity should be used when computing the weights in the WACC formula.^{ [4] }

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 and cost of equity and one type of bonds with the total market value of and cost of debt , in a country with corporate tax rate , is calculated as:

This calculation can vary significantly due to the existence of many plausible proxies for each element. As a result, a fairly wide range of values for the WACC of a given firm in a given year may appear defensible.^{ [5] }

Advantages:

- no loss of control (voting rights)
- upper limit is placed on share of profits
- flotation costs are typically lower than equity
- interest expense is tax deductible

Disadvantages:

- legally obliged to make payments no matter how tight the funds on hand are
- in the case of bonds, full face value comes due at one time
- taking on more debt = taking on more financial risk (more systematic risk) requiring higher cash flows

*The firm's debt component is stated as k _{d}* and since there is a tax benefit from interest payments then the after tax WACC component is k

Advantages:

- no legal obligation to pay (depends on class of shares)
- no maturity
- lower financial risk
- it could be cheaper than debt, with good prospects of profitability

Disadvantages:

- new equity dilutes current ownership share of profits and voting rights (control)
- cost of underwriting equity is much higher than debt
- too much equity = target for a leveraged buy-out by another firm
- no tax shield, dividends are not tax deductible, and may exhibit double-taxation

3 ways of calculating K_{e}:

- Capital Asset Pricing Model
- Dividend Discount Method
- Bond Yield Plus Risk Premium Approach

*Cost of new equity should be the adjusted cost for any underwriting fees terme flotation costs (F)*

K_{e} = D_{1}/P_{0}(1-F) + g; where F = flotation costs, D_{1} is dividends, P_{0} is price of the stock, and g is the growth rate.

Weighted average cost of capital equation:

WACC= (W_{d})[(K_{d})(1-t)]+ (W_{pf})(K_{pf})+ (W_{ce})(K_{ce})

**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.

In finance, **discounted cash flow** (**DCF**) analysis is a method of valuing a security, project, company, or asset using the concepts of the time value of money. Discounted cash flow analysis is widely used in investment finance, real estate development, corporate financial management and patent valuation. It was used in industry as early as the 1700s or 1800s, widely discussed in financial economics in the 1960s, and became widely used in U.S. courts in the 1980s and 1990s.

In finance, the **net present value** (**NPV**) or **net present worth** (**NPW**) applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount rate. NPV accounts for the time value of money. It provides a method for evaluating and comparing capital projects or financial products with cash flows spread over time, as in loans, investments, payouts from insurance contracts plus many other applications.

**Internal rate of return** (**IRR**) is a method of calculating an investment’s rate of return. The term *internal* refers to the fact that the calculation excludes external factors, such as the risk-free rate, inflation, the cost of capital, or financial risk.

In corporate finance, as part of fundamental analysis, **economic value added** is an estimate of a firm's economic profit, or the value created in excess of the required return of the company's shareholders. EVA is the net profit less the capital charge ($) for raising the firm's capital. The idea is that value is created when the return on the firm's economic capital employed exceeds the cost of that capital. This amount can be determined by making adjustments to GAAP accounting. There are potentially over 160 adjustments but in practice only several key ones are made, depending on the company and its industry.

The **Modigliani–Miller theorem** is an influential element of economic theory; it forms the basis for modern thinking on capital structure. The basic theorem states that in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. Since the value of the firm depends neither on its dividend policy nor its decision to raise capital by issuing stock or selling debt, the Modigliani–Miller theorem is often called the **capital structure irrelevance principle**.

In financial markets, **stock valuation** is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged *undervalued* are bought, while stocks that are judged *overvalued* are sold, in the expectation that undervalued stocks will overall rise in value, while overvalued stocks will generally decrease in value.

In economics and accounting, the **cost of capital** is the cost of a company's funds, or, from an investor's point of view "the required rate of return on a portfolio company's existing securities". It is used to evaluate new projects of a company. It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

In finance, the **duration** of a financial asset that consists of fixed cash flows, for example a bond, is the weighted average of the times until those fixed cash flows are received. When the price of an asset is considered as a function of yield, duration also measures the price sensitivity to yield, the rate of change of price with respect to yield or the percentage change in price for a parallel shift in yields.

**Capital structure** in corporate finance is the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. It refers to the make up of a firm's capitalisation. It is the mix of different sources of long term funds such as equity shares, preference shares, long term debt, retained earnings etc.

In finance, the **beta** is a measure of how an individual asset moves when the overall stock market increases or decreases. Thus, beta is a useful measure of the contribution of an individual asset to the risk of the market portfolio when it is added in small quantity. Thus, beta is referred to as an asset's non-diversifiable risk, its systematic risk, market risk, or hedge ratio. Beta is *not* a measure of idiosyncratic risk.

**Return on capital** (**ROC**), or **return on invested capital** (**ROIC**), is a ratio used in finance, valuation and accounting, as a measure of the profitability and value-creating potential of companies relative to the amount of capital invested by shareholders and other debtholders. It indicates how effective a company is at turning capital into profits.

In finance, **leverage** is any technique involving using debt rather than fresh equity in the purchase of an asset, with the expectation that the after-tax profit to equity holders from the transaction will exceed the borrowing cost, frequently by several multiples — hence the provenance of the word from the effect of a lever in physics, a simple machine which amplifies the application of a comparatively small input force into a correspondingly greater output force. Normally, the lender will set a limit on how much risk it is prepared to take and will set a limit on how much leverage it will permit, and would require the acquired asset to be provided as collateral security for the loan.

In finance, **return** is a profit on an investment. It comprises any change in value of the investment, and/or cash flows which the investor receives from the investment, such as interest payments or dividends. It may be measured either in absolute terms or as a percentage of the amount invested. The latter is also called the holding period return.

**Valuation using discounted cash flows** is a method of estimating the current value of a company based on projected future cash flows adjusted for the time value of money. The cash flows are made up of those within the “explicit” forecast period, together with a continuing or terminal value that represents the cash flow stream after the forecast period. In several contexts, DCF valuation is referred to as the "income approach".

In corporate finance, **Hamada’s equation**, named after Robert Hamada, is used to separate the financial risk of a levered firm from its business risk. The equation combines the Modigliani-Miller theorem with the capital asset pricing model. It is used to help determine the levered **beta** and, through this, the optimal capital structure of firms.

A **financial ratio** or **accounting ratio** is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.

In finance, the **capital structure substitution theory ** (**CSS**) describes the relationship between earnings, stock price and capital structure of public companies. The CSS theory hypothesizes that managements of public companies manipulate capital structure such that earnings per share (EPS) are maximized. Managements have an incentive to do so because shareholders and analysts value EPS growth. The theory is used to explain trends in capital structure, stock market valuation, dividend policy, the monetary transmission mechanism, and stock volatility, and provides an alternative to the Modigliani–Miller theorem that has limited descriptive validity in real markets. The CSS theory is only applicable in markets where share repurchases are allowed. Investors can use the CSS theory to identify undervalued stocks.

**Dividend policy** is concerned with financial policies regarding paying cash dividend in the present or paying an increased dividend at a later stage. Whether to issue dividends, and what amount, is determined mainly on the basis of the company's unappropriated profit and influenced by the company's long-term earning power. When cash surplus exists and is not needed by the firm, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program.

The **public market equivalent** (**PME**) is a collection of performance measures developed to assess private equity funds and to overcome the limitations of the internal rate of return and multiple on invested capital measurements. While the calculations differ, they all attempt to measure the return from deploying a private equity fund's cash flows into a stock market index.

In corporate finance, **free cash flow to equity** (**FCFE**) is a metric of how much cash can be distributed to the equity shareholders of the company as dividends or stock buybacks—after all expenses, reinvestments, and debt repayments are taken care of. It is also referred to as the **levered free cash flow** or the **flow to equity** (FTE). Whereas dividends are the cash flows actually paid to shareholders, the FCFE is the cash flow simply available to shareholders. The FCFE is usually calculated as a part of DCF or LBO modelling and valuation.

- ↑ Fernandes, Nuno. 2014, Finance for Executives: A Practical Guide for Managers, p. 32.
- ↑ G. Bennet Stewart III (1991).
*The Quest for Value*. HarperCollins. - ↑ Miles, James A.; Ezzell, John R. (September 1980). "The weighted average cost of capital, perfect capital markets and project life: a clarification".
*Journal of Financial and Quantitative Analysis*.**15**(3): 719–730. CiteSeerX 10.1.1.455.6733 . doi:10.2307/2330405. - ↑ Fernandes, Nuno. Finance for Executives: A Practical Guide for Managers. NPV Publishing, 2014, p. 30.
- ↑ Frank, Murray; Shen, Tao (2012). "Investment, Q, and the Weighted Average Cost of Capital".
*Social Science Research Network*. SSRN 2014367 .

- Video about practical application of the WACC approach
- Frank, Murray; Shen, Tao (2016). "Investment and the Weighted Average Cost of Capital".
*Journal of Financial Economics*.**119**: 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. SSRN 254587 .Missing or empty
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(help) - 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. SSRN 1526681 .Missing or empty
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