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, is not dictated by management. Rather, it 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.
In general, the WACC can be calculated with the following formula:
where is the number of sources of capital (securities, types of liabilities); is the required rate of return for security ; and is the market value of all outstanding securities .
In the case where the company is financed with only equity and debt, the average cost of capital is computed as follows:
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.
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:
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.
- Beta coefficient
- 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
- 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.
- Frank, Murray; Shen, Tao (2012). "Investment, Q, and the Weighted Average Cost of Capital". http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2014367.
- 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.
- 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