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Encyclopedia > Weighted average cost of capital

The weighted average cost of capital (WACC) is used in finance to measure a firm's cost of capital. This has been used by many firms in the past as a discount rate for financed projects, as the cost of financing (capital) is regarded by some as a logical discount rate (required rate of return) to use. Weighted Average Cost of Capital is the return a firm must earn on existing assets to keep its stock price constant and satisfy its creditors and owners. Image File history File links Emblem-important. ... Finance studies and addresses the ways in which individuals, businesses, and organizations raise, allocate, and use monetary resources over time, taking into account the risks entailed in their projects. ... The cost of capital for a firm is a weighted sum of the cost of equity and the cost of debt (see the financing decision). ... It has been suggested that this article or section be merged with Net present value. ... Capital has a number of related meanings in economics, finance and accounting. ... Discount rate as used in finance and economics is distinct from the discount rate described below; please refer to discounting and discounts. ... In finance, rate of return (ROR) or return on investment (ROI), or sometimes just return, is the ratio of money gained or lost on an investment relative to the amount of money invested. ...


Corporations raise money from two main sources: equity and debt. Thus the capital structure of a firm comprises three main components: preferred equity, common equity and debt (typically bonds and notes). The WACC takes into account the relative weights of each component of the capital structure and presents the expected cost of new capital for a firm. For other uses, see Corporation (disambiguation). ... Ownership equity, commonly known simply as equity, also risk or liable capital, is a financial term for the difference between a companys assets and liabilities -- that is, the value that accrues to the owners (sole proprieter, partners, or shareholders). ... For other uses, see Debt (disambiguation). ... Capital has a number of related meanings in economics, finance and accounting. ...

Contents

The formula

The weighted average cost of capital is defined by:

c  =  left( {E over K} right) cdot y  +  left( {D over K} right) cdot b (1-{t_C over 100})

where

 K = D + E

and the following table defines each symbol:

Symbol Meaning Units
 c  weighted average cost of capital  %
 y  required or expected rate of return on equity, or cost of equity  %
 b required or expected rate of return on borrowings, or cost of debt  %
 t_C corporate tax rate  %
 D total debt and leases (including current portion of long-term debt and notes payable) currency
 E total market value of equity and equity equivalents currency
 K total capital invested in the going concern currency


This equation describes only the situation with homogeneous equity and debt. If part of the capital consists, for example, of preferred stock (with different cost of equity y), then the formula would include an additional term for each additional source of capital. In finance, the cost of equity is the minimum rate of return a firm must offer shareholders to compensate for waiting for their returns, and for bearing some risk. ... The cost of debt is the cost of borrowing money (usually denoted by Kd). ...


or


WACC[1] = wd (1-T) rd + we re

wd = debt portion of value of corporation
T = tax rate
rd = cost of debt (rate)
we = equity portion of value of corporation
re = cost of internal equity (rate)

How it works

Since we are measuring expected cost of new capital, we should use the market values of the components, rather than their book values (which can be significantly different). In addition, other, more "exotic" sources of financing, such as convertible/callable bonds, convertible preferred stock, etc., would normally be included in the formula if they exist in any significant amounts - since the cost of those financing methods is usually different from the plain vanilla bonds and equity due to their extra features.



WACC, is a special way to measure the capital discount of the firms gaining and spending.


Sources of information

How do we find out the values of the components in the formula for WACC? First let us note that the "weight" of a source of financing is simply the market value of that piece divided by the sum of the values of all the pieces. For example, the weight of common equity in the above formula would be determined as follows:


Market value of common equity / (Market value of common equity + Market value of debt + Market value of preferred equity)


So, let us proceed in finding the market values of each source of financing (namely the debt, preferred stock, and common stock).

  • The market value for equity for a publicly traded company is simply the price per share multiplied by the number of shares outstanding, and tends to be the easiest component to find.
  • The market value of the debt is easily found if the company has publicly traded bonds. Frequently, companies also have a significant amount of bank loans, whose market value is not easily found. However, since the market value of debt tends to be pretty close to the book value (for companies that have not experienced significant changes in credit rating, at least), the book value of debt is usually used in the WACC formula.
  • The market value of preferred stock is again usually easily found on the market, and determined by multiplying the cost per share by number of shares outstanding.

Now, let us take care of the costs. For alternative meanings, see bond (a disambiguation page). ... A preferred stock, also known as a preferred share or simply a preferred, is a share of stock carrying additional rights above and beyond those conferred by common stock. ...

  • Preferred equity is equivalent to a perpetuity, where the holder is entitled to fixed payments forever. Thus the cost is determined by dividing the periodic payment by the price of the preferred stock, in percentage terms.
  • The cost of debt is the yield to maturity on the publicly traded bonds of the company. Failing availability of that, the rates of interest charged by the banks on recent loans to the company would also serve as a good cost of debt. Since a corporation normally can write off taxes on the interest it pays on the debt, however, the cost of debt is further reduced by the tax rate that the corporation is subject to. Thus, the cost of debt for a company becomes (YTM on bonds or interest on loans) × (1 − tax rate). In fact, the tax deduction is usually kept in the formula for WACC, rather than being rolled up into cost of debt, as such:
WACC = weight of preferred equity × cost of preferred equity
+ weight of common equity × cost of common equity
+ weight of debt × cost of debt × (1 − tax rate)

And now we are ready to plug all our data into the WACC formula. A preferred stock, also known as a preferred share or simply a preferred, is a share of stock carrying additional rights above and beyond those conferred by common stock. ... // A perpetuity is an annuity that has no definite end, or a stream of cash payments that continues forever. ... Common stock, also referred to as common shares, are, as the name implies, the most usual and commonly held form of stock in a corporation. ... An estimation of the CAPM and the Security Market Line (purple) for the Dow Jones Industrial Average over the last 3 years for monthly data. ... Yield to maturity (YTM) is the yield promised by the bondholder on the assumption that the bond will be held to maturity, that all coupon and principal payments will be made and coupon payments are reinvested at the bonds promised yield at the same rate as invested. ...


Effect on valuation

The economists Merton Miller and Franco Modigliani showed in the Modigliani-Miller theorem that in a perfect economy without taxes, a firm's cost of capital (and thus the valuation) does not depend on the debt to equity ratio. However, many governments allow a tax deduction on interest and thus in such an environment, there is a bias towards debt financing. Alan Greenspan, former chairman, United States Federal Reserve. ... Merton Howard Miller (May 16, 1923 – June 3, 2000) won the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel in 1990, along with Harry Markowitz and William Sharpe. ... Franco Modigliani (June 18, 1918 – September 25, 2003) was an Italian-American economist at the MIT Sloan School of Management, and winner of the Nobel Memorial Prize in Economics in 1985. ... The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. ... In finance, valuation is the process of estimating the market value of a financial asset or liability. ... The debt to equity ratio (D/E) is a financial ratio indicating the relative proportion of equity and debt used to finance a companys assets. ... A tax deduction or a tax-deductible expense represents an expense incurred by a taxpayer that is subtracted from gross income and results in a lower overall taxable income. ... For other senses of this word, see interest (disambiguation). ...


References

  • G. Bennet Stewart III (1991). The Quest for Value. HarperCollins. 
  • F. Modigliani and M. Miller, "The Cost of Capital, Corporation Finance and the Theory of Investment," American Economic Review (June 1958).
  • M. Miller and F. Modigliani. "Corporate income taxes and the cost of capital: a correction." American Economic Review, 53 (3) (1963), pp. 433-443.
  • J. Miles und J. Ezzell. "The weighted average cost of capital, perfect capital markets and project life: a clarification." Journal of Financial and Quantitative Analysis, 15 (1980), S. 719-730.

Image File history File links This is a lossless scalable vector image. ...

See also

The cost of capital for a firm is a weighted sum of the cost of equity and the cost of debt (see the financing decision). ... The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. ... It has been suggested that this article or section be merged with Net present value. ... The Minimum Acceptable Rate of Return, or MARR, is the minimum return on a project a manager is willing to accept before starting a project, given its risk and the opportunity cost of foregoing other projects. ... It has been suggested that this article or section be merged with Discounted cash flow. ... The internal rate of return (IRR) is a capital budgeting method used by firms to decide whether they should make long-term investments. ... Economic Value Added (EVA) is an estimate of true economic profit after making corrective adjustments to GAAP accounting, including deducting the opportunity cost of equity capital. ...

External links

  • Video about practical application of the WACC approach
  • Yee, Kenton K., "Earnings Quality and the Equity Risk Premium: A Benchmark Model" . Contemporary Accounting Research, Vol. 23, No. 3, pp. 833-877, Fall 2006. Available at SSRN: http://ssrn.com/abstract=921914.
  • Velez-Pareja, Ignacio and Tham, Joseph, "A Note on the Weighted Average Cost of Capital WACC" (August 7, 2005). Available at SSRN: http://ssrn.com/abstract=254587. Unpublished.
  • calculate the WACC with your own values to understand the equation
  • Paper describing a method for generating the WACC curve when there is default risk - spreadsheet available

  Results from FactBites:
 
Weighted average cost of capital - Wikipedia, the free encyclopedia (941 words)
The weighted average cost of capital (WACC) is used in finance to measure a firm's cost of capital.
The weighted average cost of capital is defined by:
The cost of debt is the yield to maturity on the publicly traded bonds of the company.
  More results at FactBites »

 
 

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