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Weighted average cost of capital

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Title: Weighted average cost of capital  
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Subject: Discounted cash flow, Corporate finance, Adjusted present value, Cost of equity, Net present value
Collection: Capital (Economics), Mathematical Finance
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Weighted average cost of capital

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, 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]

Contents

  • Calculation 1
    • Tax effects 1.1
  • See also 2
  • References 3
  • External links 4

Calculation

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

\text{WACC} = \frac{\sum_{i=1}^N r_i \cdot MV_i }{\sum_{i=1}^N MV_i}

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

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

\text{WACC} = \frac{D}{D+E}K_d + \frac{E}{D+E}K_e

where D is the total debt, E is the total shareholder’s equity, Ke is the cost of equity, and Kd is the cost of debt. The market values of debt and equity should be used when computing the weights in the WACC formula.[1]

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

\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.[4]

See also

References

  1. ^ a b 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.  
  4. ^ Frank, Murray; Shen, Tao (2012). "Investment, Q, and the Weighted Average Cost of Capital". http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2014367. 

External links

  • Video about practical application of the WACC approach
  • Frank, Murray; Shen, Tao (2012). "Investment, Q, and the Weighted Average Cost of Capital". SSRN. 
  • 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. 
  • 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. 
  • 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.
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