Weighted average cost of capital

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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]

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.

Contents

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.

Common stock form of corporate equity ownership, a type of security

Common stock is a form of corporate equity ownership, a type of security. The terms voting share and ordinary share are also used frequently in other parts of the world; "common stock" being primarily used in the United States. They are known as Equity shares or Ordinary shares in the UK and other Commonwealth realms. This type of share gives the stockholder the right to share in the profits of the company, and to vote on matters of corporate policy and the composition of the members of the board of directors.

Preferred stock type of stock which may have any combination of features not possessed by common stock

Preferred stock is a form of stock which may have any combination of features not possessed by common stock including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferred stocks are senior to common stock, but subordinate to bonds in terms of claim and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are described in the issuing company's articles of association or articles of incorporation.

Debt deferred payment, or series of payments, that is owed in the future

Debt is when something, usually money, is owed by one party, the borrower or debtor, to a second party, the lender or creditor. Debt is a deferred payment, or series of payments, that is owed in the future, which is what differentiates it from an immediate purchase. The debt may be owed by sovereign state or country, local government, company, or an individual. Commercial debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes, and mortgages are all types of debt. The term can also be used metaphorically to cover moral obligations and other interactions not based on economic value. For example, in Western cultures, a person who has been helped by a second person is sometimes said to owe a "debt of gratitude" to the second person.

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

Calculation

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 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.

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]

In finance, the cost of equity is the return a firm theoretically pays to its equity investors, i.e., shareholders, to compensate for the risk they undertake by investing their capital. Firms need to acquire capital from others to operate and grow. Individuals and organizations who are willing to provide their funds to others naturally desire to be rewarded. Just as landlords seek rents on their property, capital providers seek returns on their funds, which must be commensurate with the risk undertaken.

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 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]


Components

Debt

Advantages:

Disadvantages:


The firm's debt component is stated as kd and since there is a tax benefit from interest payments then the after tax WACC component is kd(1-T); where T is the tax rate.

Equity

Advantages:

Disadvantages:

3 ways of calculating KKe:

  1. Capital Asset Pricing Model
  2. Dividend Discount Method
  3. Bond Yield Plus Risk Premium Approach

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

Ke = D1/P0(1-F) + g; where F = flotation costs, D1 is dividends, P0 is price of the stock, and g is the growth rate.

Weighted average cost of capital equation:

WACC= (Wd)[(Kd)(1-t)]+ (Wpf)(Kpf)+ (Wce)(Kce)

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.

See also

Related Research Articles

In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted by using cost of capital to give their present values (PVs). The sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value of the cash flows in question.

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.

Economic value added

In corporate finance, as part of fundamental analysis, economic value added (EVA) 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. EVA is a service mark of Stern Value Management.

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.

The APV was introduced in 1974 bij Stewart Myers. According to Myers, the value of the levered firm is equal to the value of the firm with no debt plus the present value of the tax savings due to the tax deductability of interest payments, the so called value of the tax shield (VTS). Myers proposes calculating the VTS by discounting the tax savings at the cost of debt (Kd). The argument is that the risk of the tax saving arising from the use of debt is the same as the risk of the debt. The method is to calculate the NPV of the project as if it is all-equity financed. Then the base-case NPV is adjusted for the benefits of financing. Usually, the main benefit is a tax shield resulted from tax deductibility of interest payments. Another benefit can be a subsidized borrowing at sub-market rates. The APV method is especially effective when a leveraged buyout case is considered since the company is loaded with an extreme amount of debt, so the tax shield is substantial.

Bond duration

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

Capital structure in corporate finance is the way a corporation finances its assets through some combination of equity, debt, or hybrid securities.

Tobin's q is the ratio between a physical asset's market value and its replacement value. It was first introduced by Nicholas Kaldor in 1966 in his article "Marginal Productivity and the Macro-Economic Theories of Distribution: Comment on Samuelson and Modigliani". It was popularised a decade later, however, by James Tobin, who describes its two quantities (1977):

One, the numerator, is the market valuation: the going price in the market for exchanging existing assets. The other, the denominator, is the replacement or reproduction cost: the price in the market for newly produced commodities. We believe that this ratio has considerable macroeconomic significance and usefulness, as the nexus between financial markets and markets for goods and services.

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 after taking into account the amount of initial capital invested. The ratio is calculated by dividing the after-tax operating income (NOPAT) by the book value of both debt and equity capital less cash/equivalents.

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Financial ratio characteristic number

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.

Corporate finance area of finance dealing with the sources of funding and the capital structure of corporations

Corporate finance is an area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.

Public Market Equivalent designs a set of analyses used in the Private Equity Industry to evaluate the performance of a Private Equity Fund against a public benchmark or index. The analysis is also referred by the acronym ICM for Index Comparison Method. More than a specific calculation method, PME encompasses a number of different analyses sharing the same objective. The first PME analysis was proposed by Long and Nickels in 1996.

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. 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. The FCFE is also called the levered free cash flow.

References

  1. Fernandes, Nuno. 2014, Finance for Executives: A Practical Guide for Managers, p. 32.
  2. G. Bennet Stewart III (1991). The Quest for Value. HarperCollins.
  3. 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.
  4. Fernandes, Nuno. Finance for Executives: A Practical Guide for Managers. NPV Publishing, 2014, p. 30.
  5. Frank, Murray; Shen, Tao (2012). "Investment, Q, and the Weighted Average Cost of Capital". Social Science Research Network. SSRN   2014367 .