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.

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.

Video Weighted average cost of capital

Calculation

In general, the WACC can be calculated with the following formula:

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

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.

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:

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

Actually carrying out this calculation has a problem. There are many plausible proxies for each element. As a result, a fairly wide range of values for the WACC for a given firm in a given year, may appear defensible.

Maps Weighted average cost of capital

WACC components

Debt

Advantages:

• usually cheaper than equity
  
• 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_d(1-T); where T is the tax rate.

Equity

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 KK_e:

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)

K_e = 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= (W_d)[(K_d)(1-t)]+ (W_pf)(K_pf)+ (W_ce)(K_ce)

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Marginal cost of capital schedule

Marginal cost of capital (MCC) schedule is a graph that relates the firm's weighted average cost of each unit of capital to the total amount of new capital raised.

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See also

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

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References

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External links

• Video about practical application of the WACC approach
• Frank, Murray; Shen, Tao (2016). "Investment and the Weighted Average Cost of Capital". SSRN - Journal of Financial Economics. 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 . 
• 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 . 

Tools to find WACC

• A rather complete WACC calculator
• Another very basic WACC calculator
• A more realistic valuation: APV and WACC with constant book leverage ratio
• Calculate the WACC with your own values to understand the equation
• Find the WACC of any publicly traded company by entering the firm's stock ticker symbol
• Paper describing a method for generating the WACC curve when there is default risk - spreadsheet available
• Tutorial how to calculate WACC in Excel.
• Infographic: EVA-WACC Tree Model

Source of the article : Wikipedia