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]

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.^[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 $MV_{e}$ 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.^[5]

References

↑ Fernandes, Nuno. 2014, Finance for Executives: A Practical Guide for Managers, p. 32.
↑ G. Bennet Stewart III (1991). The Quest for Value. HarperCollins.
↑ 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. doi:10.2307/2330405.
↑ Fernandes, Nuno. Finance for Executives: A Practical Guide for Managers. NPV Publishing, 2014, p. 30.
↑ Frank, Murray; Shen, Tao (2012). "Investment, Q, and the Weighted Average Cost of Capital". Social Science Research Network.

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.

Tools to find WACC

Corporate finance and investment banking

Capital structure

Transactions
(terms / conditions)

Equity offerings	At-the-market offering Book building Bookrunner Corporate spin-off Equity carve-out Follow-on offering Greenshoe Reverse Initial public offering Private placement Public offering Rights issue Seasoned equity offering Secondary market offering Underwriting

Mergers and acquisitions	Buy side Control premium Demerger Divestment Drag-along right Management due diligence Managerial entrenchment Minority discount Pitch book Pre-emption right Proxy fight Post-merger integration Sell side Shareholder rights plan Special situation Squeeze out Staggered board of directors Stock swap Super-majority amendment Tag-along right Takeover Reverse Tender offer

Leverage	Debt restructuring Debtor-in-possession financing Financial sponsor Leveraged buyout Leveraged recapitalization High-yield debt Private equity Project finance

Valuation

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