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

_{d}'' and since there is a tax benefit from interest payments then the after tax WACC component is k_{d}(1-T); where T is the

_{d}) d)(1-t)">K_{d})(1-t) (W_{pf})(K_{pf})+ (W_{ce})(K_{ce})
Cost of new equity should be the adjusted cost for any underwriting fees termed flotation costs (F):
K_{e} = D_{1}/P_{0}(1-F) + g; where F = _{1} is dividends, P_{0} is price of the stock, and g is the growth rate.
There are 3 ways of calculating K_{e}:
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Video about practical application of the WACC approach

* * * {{DEFAULTSORT:Weighted Average Cost Of Capital Financial capital Mathematical finance Production economics Economics curves Costs

cost of capital
In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate ne ...

. 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.Fernandes, Nuno. 2014, Finance for Executives: A Practical Guide for Managers, p. 32.
Companies raise money from a number of sources: common stock
Common stock is a form of corporate equity ownership, a type of security. The terms voting share and ordinary share are also used frequently outside of the United States. They are known as equity shares or ordinary shares in the UK and other Co ...

, preferred stock
Preferred stock (also called preferred shares, preference shares, or simply preferreds) is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt in ...

and related rights, straight debt
Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The ...

, convertible debt
In finance, a convertible bond or convertible note or convertible debt (or a convertible debenture if it has a maturity of greater than 10 years) is a type of bond that the holder can convert into a specified number of shares of common stock i ...

, exchangeable debt, employee stock option
Employee stock options (ESO) is a label that refers to compensation contracts between an employer and an employee that carries some characteristics of financial options.
Employee stock options are commonly viewed as an internal agreement prov ...

s, pension liabilities, executive stock options, 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
In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders' equity, debt (borrowed funds), and preferred stock, and is detailed in the ...

. 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.
Calculation

In general, the WACC can be calculated with the following formula: $\backslash text\; =\; \backslash frac$ where $N$ is the number of sources of capital (securities, types of liabilities); $r\_i$ is the requiredrate of return
In finance, return is a profit on an investment. It comprises any change in value of the investment, and/or cash flows (or securities, or other investments) which the investor receives from that investment, such as interest payments, coupons, ...

for security $i$; and $MV\_i$ is the market value of all outstanding securities $i$.
In the case where the company is financed with only equity and debt, the average cost of capital is computed as follows:
$\backslash text\; =\; \backslash fracK\_d\; +\; \backslash fracK\_e$
where $D$ is the total debt, $E$ is the total shareholder's equity, $K\_d$ is the cost of debt, and $K\_e$ is the cost of equity. The market values of debt and equity should be used when computing the weights in the WACC formula.Fernandes, Nuno. Finance for Executives: A Practical Guide for Managers. NPV Publishing, 2014, p. 30.
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 $MV\_e$ and cost of equity $R\_e$ and one type of bonds with the total market value of $MV\_d$ and cost of debt $R\_d$, in a country with corporate tax rate $t$, is calculated as: $\backslash text\; =\; \backslash frac\; \backslash cdot\; R\_e\; +\; \backslash frac\; \backslash cdot\; R\_d\; \backslash cdot\; (1-t)$ 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.Components

Debt

''The firm's debt component is stated as ktax rate
In a tax system, the tax rate is the ratio (usually expressed as a percentage) at which a business or person is taxed. There are several methods used to present a tax rate: statutory, average, marginal, and effective. These rates can also be ...

.
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 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
Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financia ...

(more systematic risk
In finance and economics, systematic risk (in economics often called aggregate risk or undiversifiable risk) is vulnerability to events which affect aggregate outcomes such as broad market returns, total economy-wide resource holdings, or aggreg ...

) requiring higher cash flows.
Equity

Weighted average cost of capital equation: WACC= (Wflotation cost Flotation cost is the total cost incurred by a company in offering its securities to the public. It arises from expenses such as underwriting fees, legal fees and registration fees. Firms are well-advised to consider the magnitude of these fees, as ...

s, DCapital Asset Pricing Model
In finance, the capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio.
The model takes into acc ...

# Dividend Discount Method
#Bond Yield Plus Risk Premium
A risk premium is a measure of excess return that is required by an individual to compensate being subjected to an increased level of risk. It is used widely in finance and economics, the general definition being the expected risky return less ...

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 voting rights
Suffrage, political franchise, or simply franchise, is the right to vote in public, political elections and referendums (although the term is sometimes used for any right to vote). In some languages, and occasionally in English, the right to v ...

(impacting control),
cost of underwriting
Underwriting (UW) services are provided by some large financial institutions, such as banks, insurance companies and investment houses, whereby they guarantee payment in case of damage or financial loss and accept the financial risk for liabil ...

for equity is much higher than for debt,
too much equity = target for a leveraged buy-out by another firm, and
no tax shield
A tax shield is the reduction in income taxes that results from taking an allowable deduction from taxable income. For example, because interest on debt is a tax-deductible expense, taking on debt creates a tax shield. Since a tax shield is a wa ...

, dividends are not tax deductible, and may exhibit double taxation
Double taxation is the levying of tax by two or more jurisdictions on the same income (in the case of income taxes), asset (in the case of capital taxes), or financial transaction (in the case of sales taxes).
Double liability may be mitigated ...

.
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 usinginternal rate of return
Internal rate of return (IRR) is a method of calculating an investment’s rate of return. The term ''internal'' refers to the fact that the calculation excludes external factors, such as the risk-free rate, inflation, the cost of capital, or fi ...

(IRR). The higher the IRR the better off a project is.
See also

* Beta coefficient *Capital asset pricing model
In finance, the capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio.
The model takes into acc ...

*Cost of capital
In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate ne ...

*Discounted cash flow
The discounted cash flow (DCF) analysis is a method in finance of valuing a security, project, company, or asset using the concepts of the time value of money.
Discounted cash flow analysis is widely used in investment finance, real estate deve ...

* Economic value added
*Hamada's equation In corporate finance
Corporate finance is the area of finance that deals with the sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholder
A shareholder ...

*Internal rate of return
Internal rate of return (IRR) is a method of calculating an investment’s rate of return. The term ''internal'' refers to the fact that the calculation excludes external factors, such as the risk-free rate, inflation, the cost of capital, or fi ...

* Minimum acceptable rate of return
*Modigliani–Miller theorem
The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) is an influential element of economic theory; it forms the basis for modern thinking on capital structure. The basic theorem states that in the absence of taxes, bankruptcy cos ...

*Net present value
The net present value (NPV) or net present worth (NPW) applies to a series of cash flows occurring at different times. The present value of a cash flow depends on the interval of time between now and the cash flow. It also depends on the discount ...

*Opportunity cost
In microeconomic theory, the opportunity cost of a particular activity is the value or benefit given up by engaging in that activity, relative to engaging in an alternative activity. More effective it means if you chose one activity (for exampl ...

References

External links

Video about practical application of the WACC approach

* * * {{DEFAULTSORT:Weighted Average Cost Of Capital Financial capital Mathematical finance Production economics Economics curves Costs