Weighted average cost of capital

The WACC structure: It averages the cost of equity and the after-tax cost of debt based on their respective weights in the company's capital structure.

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]

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. ^[2]

Calculation

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

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

where ${\displaystyle N}$ is the number of sources of capital (securities, types of liabilities); ${\displaystyle r_{i}}$ is the required rate of return for security ${\displaystyle i}$; and ${\displaystyle MV_{i}}$ is the market value of all outstanding securities ${\displaystyle i}$.

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

${\displaystyle {\text{WACC}}={\frac {D}{D+E}}K_{d}+{\frac {E}{D+E}}K_{e}}$

where ${\displaystyle D}$ is the total debt, ${\displaystyle E}$ is the total shareholder's equity, ${\displaystyle K_{d}}$ is the cost of debt, and ${\displaystyle K_{e}}$ 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

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 ${\displaystyle MV_{e}}$ and cost of equity ${\displaystyle R_{e}}$ and one type of bonds with the total market value of ${\displaystyle MV_{d}}$ and cost of debt ${\displaystyle R_{d}}$, in a country with corporate tax rate ${\displaystyle t}$, is calculated as:

${\displaystyle {\text{WACC}}={\frac {MV_{e}}{MV_{d}+MV_{e}}}\cdot R_{e}+{\frac {MV_{d}}{MV_{d}+MV_{e}}}\cdot R_{d}\cdot (1-t)}$

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

The cost of debt component in WACC. As debt increases, the after-tax cost $k_d(1-T)$ remains a primary driver of the overall weighted average until financial risk premiums rise.

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_d(1-T); where T is the tax rate. ^[6]

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:

${\displaystyle {\text{WACC}}=w_{d}\cdot [K_{d}(1-t)]+w_{pf}\cdot K_{pf}+w_{ce}\cdot K_{ce}}$

When issuing new common equity, the cost must be adjusted for underwriting fees, termed flotation costs (F). The adjusted cost of equity (${\displaystyle K_{e}}$) is calculated as:

${\displaystyle K_{e}={\frac {D_{1}}{P_{0}(1-F)}}+g}$

where:

• ${\displaystyle D_{1}}$ is the expected dividend,
• ${\displaystyle P_{0}}$ is the current stock price,
• ${\displaystyle F}$ is the flotation cost percentage,
• ${\displaystyle g}$ is the dividend growth rate.

There are 3 ways of calculating K_e:

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

The equity component has advantages for the firm including: no legal obligation to pay (depends on class of shares) as opposed to debt, no maturity (unlike e.g. bonds), lower financial risk, and it could be cheaper than debt with good prospects of profitability. But also disadvantages including: new equity dilutes current ownership share of profits and voting rights (impacting control), cost of underwriting for equity is much higher than for debt, too much equity = target for a leveraged buy-out by another firm, and no tax shield, dividends are not tax deductible, and may exhibit double taxation.

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)

WACC approach to enterprise valuation: Future operating free cash flows are discounted to their present value using the weighted average cost of capital.

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 ${\displaystyle N_{0}}$—is determined by the following formula:

${\displaystyle {\text{Enterprise Value}}=\sum _{t=1}^{\infty }{\frac {OFCF_{t}}{(1+WACC_{t})^{t}}}+N_{0}}$

The Operating Free Cash Flow (OFCF) represents the cash surplus available as if the company were entirely equity-financed. The tax shield from debt is accounted for by reducing the WACC (the discount rate). Consequently, the firm's actual capital structure is reflected in the denominator rather than the numerator.

Contrary to common belief, the WACC method does not strictly require a constant capital structure. ^[7] However, if the leverage ratio changes over time, the WACC must be adjusted using the Miles-Ezzell adjustment formula. ^[8]

The Modigliani-Miller adjustment formula is generally not applicable here as it assumes a constant absolute amount of debt (autonomous financing), which contradicts market-value-oriented financing where debt levels are adjusted to keep pace with the company's valuation. ^[9]

See also

• Beta coefficient
• Capital asset pricing model
• Cost of capital
• Discounted cash flow
• Economic value added
• Hamada's equation
• Internal rate of return
• Minimum acceptable rate of return
• Modigliani–Miller theorem
• Net present value
• Opportunity cost

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. JSTOR   2330405. S2CID   154350056.
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.
6. Hargrave, Marshall. "Weighted Average Cost of Capital (WACC) Definition". investopedia.com. Investopedia. Retrieved 20 May 2022.
7. Löffler, A. (2004). "WACC and the Cost of Capital," Journal of Business.
8. Miles, J. and Ezzell, J. (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.
9. Modigliani, F. and Miller, M. (1963). "Corporate Income Taxes and the Cost of Capital: A Correction," American Economic Review, 53(3), 433–443.

External links

• 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 (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. SSRN   254587.{{cite journal}}: Cite journal requires |journal= (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.{{cite journal}}: Cite journal requires |journal= (help)