Editing Weighted average cost of capital

{{Short description|Concept in economics}}
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.<ref name="Nuno Fernandes">Fernandes, Nuno. 2014, Finance for Executives: A Practical Guide for Managers, p. 32.</ref>

Companies raise money from a number of sources: [[common stock]], [[preferred stock]] and related rights, straight [[debt]], [[Convertible bond|convertible debt]], [[Exchangeable bond|exchangeable debt]], [[employee stock option]]s, [[Pension|pension liabilities]], [[executive stock option]]s, 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.<ref>{{cite book | author=G. Bennet Stewart III | title = The Quest for Value | publisher = HarperCollins | year = 1991}}</ref>

==Calculation==
In general, the WACC can be calculated with the following formula:<ref>{{cite journal |first1=James A. |last1=Miles |first2= John R. |last2=Ezzell |title=The weighted average cost of capital, perfect capital markets and project life: a clarification |journal=Journal of Financial and Quantitative Analysis |volume=15 |number=3 |date=September 1980 |pages=719–730 |doi=10.2307/2330405|jstor=2330405 |citeseerx=10.1.1.455.6733 |s2cid=154350056 }}</ref>

<math>\text{WACC}  = \frac{\sum_{i=1}^N r_i \cdot MV_i }{\sum_{i=1}^N MV_i}</math>

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

In the case where the company is financed with only [[Equity (finance)|equity]] and debt, the average cost of capital is computed as follows:

<math>\text{WACC}  = \frac{D}{D+E}K_d + \frac{E}{D+E}K_e</math>

where <math>D</math> is the total debt, <math>E</math> is the total shareholder's equity, <math>K_d</math> is the [[Cost of capital#Cost of debt|cost of debt]], and <math>K_e</math> is the [[cost of equity]]. The market values of debt and equity should be used when computing the weights in the WACC formula.<ref name="Nuno Fernandes 2">Fernandes, Nuno. Finance for Executives: A Practical Guide for Managers. NPV Publishing, 2014, p. 30.</ref>

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

<math>\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)</math>

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.<ref>{{cite journal |first1=Murray |last1=Frank |first2= Tao |last2=Shen |title=Investment, Q, and the Weighted Average Cost of Capital |ssrn= 2014367 |journal=Social Science Research Network|year=2012 }}</ref>

==Components==

===Debt===
''The firm's debt component is stated as k<sub>d</sub>'' and since there is a tax benefit from interest payments then the after tax WACC component is k<sub>d</sub>(1-T); where T is the [[Tax|tax rate]].<ref>{{cite web |last1=Hargrave |first1=Marshall |title=Weighted Average Cost of Capital (WACC) Definition |url=https://www.investopedia.com/terms/w/wacc.asp |website=investopedia.com |publisher=Investopedia |access-date=20 May 2022}}</ref>

Increasing the debt component under WACC has advantages including:
no loss of control (voting rights) that would come from other sources,
upper limit is placed on share of profits,
flotation costs are typically lower than equity, and
interest expense is [[Tax deduction|tax deductible]].
But there are also disadvantages of the debt component including:
Using WACC makes the firm 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, and
taking on more debt = taking on more [[financial risk]] (more [[systematic risk]]) requiring higher cash flows.

===Equity===
Weighted average cost of capital equation:
WACC= (W<sub>d</sub>)[(K<sub>d</sub>)(1-t)]+ (W<sub>pf</sub>)(K<sub>pf</sub>)+ (W<sub>ce</sub>)(K<sub>ce</sub>)

Cost of new equity should be the adjusted cost for any underwriting fees termed flotation costs (F):
K<sub>e</sub> = D<sub>1</sub>/P<sub>0</sub>(1-F) + g; where F = [[flotation cost]]s, D<sub>1</sub> is dividends, P<sub>0</sub> is price of the stock, and g is the growth rate.

There are 3 ways of calculating K<sub>e</sub>:
#[[Capital asset pricing model|Capital Asset Pricing Model]]
#[[Dividend discount model|Dividend Discount Method]]
#Bond Yield Plus [[Risk premium|Risk Premium]] Approach

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, and
it could be cheaper than debt with good prospects of profitability.
But also disadvantages including:
new equity dilutes current ownership share of profits and [[Suffrage|voting rights]] (impacting control),
cost of [[underwriting]] for equity is much higher than for debt,
too much equity = target for a [[Leveraged buyout|leveraged buy-out]] by another firm, and
no [[tax shield]], dividends are not tax deductible, and may exhibit [[double taxation]].

==Marginal cost of capital schedule==
'''Marginal cost of capital''' ('''MCC''') '''schedule''' or an '''investment 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 using [[internal rate of return]] (IRR). The higher the IRR the better off a project is.

==See also==
{{div col|colwidth=22em}}
*[[Beta (finance)|Beta coefficient]]
*[[Capital asset pricing model]]
*[[Cost of capital]]
*[[Discounted cash flow]]
*[[Economic value added]]
*[[Hamada's equation]]
*[[Internal rate of return]]
*[[Minimum acceptable rate of return]]
*[[Modigliani–Miller theorem]]
*[[Net present value]]
*[[Opportunity cost]]
{{div col end}}

==References==
{{Reflist}}

==External links==
* [http://www.wacc.de/index.htm#Example Video about practical application of the WACC approach]
* {{cite journal |last1=Frank |first1=Murray |last2=Shen |first2=Tao |title=Investment and the Weighted Average Cost of Capital |date= 2016 |ssrn=2014367  |doi=10.1016/j.jfineco.2015.09.001 |volume=119 |journal=Journal of Financial Economics |issue=2 |pages=300–315}} 
* {{cite journal |last1=Velez-Pareja |first1=Ignacio |last2=Tham |first2=Joseph |title=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 |date=August 7, 2005 |ssrn=254587 |publisher=SSRN}}
* {{cite journal |last=Cheremushkin |first=Sergei Vasilievich |title=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 |date=December 21, 2009 |ssrn=1526681 |publisher=SSRN}}

{{Corporate finance and investment banking}}

{{DEFAULTSORT:Weighted Average Cost Of Capital}}
[[Category:Financial capital]]
[[Category:Mathematical finance]]
[[Category:Production economics]]
[[Category:Economics curves]]
[[Category:Costs]]