Theweighted 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'scost 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 thecapital structure.
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 requiredrate of return for security; and is the market value of all outstanding securities.
In the case where the company is financed with onlyequity and debt, the average cost of capital is computed as follows:
where is the total debt, is the total shareholder's equity, is thecost of debt, and is thecost 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]
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 thetax rate.[6]
Increasing the debt component under WACC has advantages including:
But there are also disadvantages including:
The weighted average cost of capital equation including preferred stock is:
When issuing new common equity, the cost must be adjusted for underwriting fees, termed flotation costs (F). The adjusted cost of equity () is calculated as:
where:
There are 3 ways of calculating Ke:
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, andit could be cheaper than debt with good prospects of profitability.But also disadvantages including:new equity dilutes current ownership share of profits andvoting rights (impacting control),cost ofunderwriting for equity is much higher than for debt,too much equity = target for aleveraged buy-out by another firm, andnotax shield, dividends are not tax deductible, and may exhibitdouble taxation.
Marginal cost of capital (MCC)schedule or aninvestment 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 usinginternal rate of return (IRR). The higher the IRR the better off a project is.
The WACC approach is the most widely used variant of theDiscounted 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—is determined by the following formula:
TheOperating Free Cash Flow (OFCF) represents the cash surplus available as if the company were entirely equity-financed. Thetax 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 doesnot strictly require a constantcapital structure.[7] However, if the leverage ratio changes over time, the WACC must be adjusted using theMiles-Ezzell adjustment formula.[8]
TheModigliani-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]
