Weighted average cost of
capital
The weighted average cost of
capital (WACC) is used in finance to measure a firm’s cost of capital. It had
been used by many firms in the past as a discount rate for financed projects,
since using the cost of the financing seems like a logical price tag to put on
it.
Companies 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
The weighted average cost of
capital is defined by C = (E/K)
y + (D/K) b (1 – Xc) Where, K = D + E The
following table defines each symbol
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
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.
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
Preferred equity is equivalent to 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 common equity is usually determined using the capital asset pricing model
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)