WACC

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WACC
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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.

\(\text{WACC} = \left ({E \over {V}}\right) \cdot r_E + \left ({D \over {V}} \right) \cdot r_D \left (1-T_c\right)\) , where:

  • \(\ D \) is the value of debt,
  • \(\ E \) is the value of equity,
  • \(\ V \) is the market value of the company,
  • \(\ T_C \) is the tax rate,
  • \(\ r_D \) is the cost of debt,
  • \(\ r_E \) 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 1 USD million of debt and 100,000 of shares at 50 USD 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 = 1 USD million

E = 100,000 shares X 50 USD/share = 5 USD million

V = D + E = 1 + 5 = 6 USD million

WACC = (100%-15%) x (1/5 X 8%) + (4/5 x 15%) = 13,36%

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