WACC
Weighted Average Cost of Capital (WACC) is a calculation of a firm's overall cost of capital in which each category of capital is proportionately weighted. All capital sources - stocks, bonds and any other long-term debt - are included in a WACC calculation.
Generally speaking, all of the company's assets are financed by one of the following: debt or equity. WACC is the average of the real costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances. A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm.
, where:
- is the value of debt,
- is the value of equity,
- is the market value of the company,
- is the tax rate,
- is the cost of debt,
- is the cost of equity.
It is also worth mentioning that Damodaran along with Brealey, Myers and Farber, Gillet, Szafarz do not include the corporate tax rate in the WACC calculation. That is possibly mainly because, as Sabal suggests, that although WACC is appropriate for project and firm valuation, it is not a good rule of thumb for investment decision making. The reason is that by mixing up the value of the project itself with the tax shield, WACC can often turn unattractive projects into apparently acceptable ones. Real investments must be accepted only if they yield positive Net Present Value (NPV) when discounted at the unleveraged discount rate, that is, without accounting for the tax shield. WACC enters the picture only to assess the impact of a new project on firm value, once it has been accepted, and when a fixed debt ratio policy is in place.
Example
Example - A firm has US$1 million of debt and 100,000 of shares at US$50 each. If they can borrow at 8% and the stockholders require 15% return what is the firm's WACC? The corporate tax is 15%.
D = US$1 million
E = 100,000 shares X US$50/share = US$5 million
V = D + E = 1 + 5 = US$6 million
WACC = (100%-15%) x (1/5 X 8%) + (4/5 x 15%) = 13,36%
Advantages of WACC
The Weighted Average Cost of Capital (WACC) is a useful tool for measuring a company's cost of capital. There are several advantages to using the WACC calculation for financial decision making. These include:
- It provides an overall cost of capital for the company, which can be used to evaluate the performance of potential investments.
- It helps to identify and compare the costs of different sources of capital.
- It allows management to assess the impact of changes in capital structure on the overall cost of capital.
- It takes into account the varying costs of different types of capital and the relative proportions of each.
- It helps to ensure that the company is not taking on too much debt or equity, and is using the optimal combination of the two.
Limitations of WACC
The limitations of Weighted Average Cost of Capital (WACC) include:
- Assumptions of static capital structure: WACC assumes that the capital structure of the company remains fixed over time. This can be an inaccurate assumption as companies may adjust their capital structures depending on various factors.
- Assumptions of market values: WACC assumes that the market values of the various components of capital accurately reflect their true value. This can be a false assumption as the market values may not always reflect the value of an individual asset or liabilities.
- Assumptions of equal risk: WACC assumes that the risk of all components of capital are equal. This can be an inaccurate assumption as different components of capital may have different levels of risk.
- Assumptions of a fixed cost of capital: WACC assumes that the cost of capital remains fixed over time. This can be an inaccurate assumption as the cost of capital can change over time due to changes in interest rates or market conditions.
- Assumptions of no taxes: WACC assumes that taxes do not exist and that all returns are tax free. This can be a false assumption as taxes can affect the cost of capital.
One way to look at WACC is to consider other approaches related to it. These include:
- The Discounted Cash Flow (DCF) approach - This approach looks at the present value of a company’s future cash flows to calculate its cost of capital. The discount rate used is the WACC.
- The Capital Asset Pricing Model (CAPM) - This approach uses the concept of risk and return to calculate the cost of capital. The cost of equity is calculated based on the risk-free rate, beta, and the market risk premium.
- The Weighted Average Cost of Capital (WACC) - This approach uses a weighted average of the cost of equity and the cost of debt to calculate a company's cost of capital.
In summary, there are several approaches related to WACC that can be used to calculate a company’s cost of capital. These include the DCF approach, the CAPM approach, and the WACC approach. Each approach has its own advantages and disadvantages and can be used to calculate a company’s cost of capital.
WACC — recommended articles |
Running yield — Annualized rate — Free cash flow yield — Economic value of equity — Gordon Growth Model — Market value ratios — Market Risk Premium — Earnings per share — Net present value (NPV) |
References
- Brealey R.A., Myers S.C., Principles of Corporate Finance, McGraw Hill, 1996
- Damodaran A., Investment valuation Second Edition, Wiley Publishing, 2002, p. 4
- Farber A., Gillet R.L., Szafarz A., A General Formula for the WACC, "International Journal of Business" Vol. 11, No. 2, 2006
- Fernandez, P. (2007). A More Realistic Valuation: APV and WACC with constant book leverage ratio.
- Jacobs J.F., The One and Only Standard WACC - Cost of Capital versus Return on Capital, JBA-Databank Working Paper Series, July 2005
- Modigliani F., Miller M.H., The Cost of Capital, Corporation Finance and the Theory of Investment, "The American Economic Review", Vol. 48, No. 3 June 1958, p. 261-297
- Sabal J., On the Applicability of WACC for Investment Decisions, "Journal: Globalization, Competitiveness & Governability" Vol. 3 Num. 2, Georgetown University, 2009
- Stanton R.H., Seasholes M.S., The Assumptions and Math Behind Wacc and Apv Calculations, U.C. Berkeley Working Paper Series, October 2005
Author: Łukasz Skarka