Weighted Average Cost of Capital

The weighted average cost of capital (WACC) is an important topic in finance, it is also called the discount rate and used in evaluating whether a project is feasible or not in the net present value (NPV) analysis, or in assessing the value of an asset. The WACC is also referred to as the marginal cost of capital (MCC) because it is the cost that a company incurs for additional capital. The weights in this weighted average are the proportions of the various sources of capital that the company uses to support its investment program.

 

Weighted Average Cost of Capital Formula

When calculating the weighted average cost of capital for a business or project, you can use the following formula:

WACC= WdRD(1-t) + WpRp + WeRe

Where:

Wd = the proportion of debt that the company uses when it raises new funds
Rd= the before-tax marginal cost of debt
t = the company's marginal tax rate
Wp = the proportion of preferred stock the: company uses when it raises new funds
Rp = the marginal cost of preferred stock
We = the proportion of equity that the company uses when it raises new funds
Re = the marginal cost of equity

Cost of Debt

In the above wacc equation,  we adjust the expected before-tax cost on new debt financing, rd, by a factor of ( 1 - t). In the United States and many other tax jurisdictions,the interest on debt financing is a deduction to arrive at taxable income. Taking the tax-deductibility of interest as the base case, we adjust the pre-tax cost of debt for this tax shield. Multiplying Rd by (1 - t) results in an estimate of the after-tax cost of debt.

Cost of Equity

Estimating the cost of common equity capital is more challenging than estimating the cost of debt capital. Debt capital involves a stated legal obligation on the part of the company to pay interest and repay the principal on the borrowing. Equity entails no such obligation. Estimating the cost of conventional preferred equity is rather straightforward because the dividend is generally stated and fixed, but estimating the cost of common equity is challenging. There are several methods available for estimating the cost of common equity, and we discuss two in this reading. The first method uses the capital asset pricing model, and the second method uses the dividend discount model, which is based on discounted cash flows. No matter the method, there is no need to make any adjustment in the cost of equity for taxes because the payments to owners, whether in the form of dividends or the return on capital, are not tax-deductible for the company.

Weights in Weighted Average Cost of Capital

How do we determine what weights to use? Ideally, we want to use the proportion of each source of capital that the company would use in the project or company. If we assume that a company has a target capital structure and raises capital consistent with this target, we should use this target capital structure. The target capital structure is the capital structure that a company is striving to obtain. If we know the company's target capital structure, then, of course, we should use this in our analysis., however, Analyst typically does not know the target capital structure and must estimate it using one of several approaches:

  • Assume the company's current capital structure, at market value weights for the components
  • Examine trends in the company's capital structure or statements by management regarding capital structure policy to infer the target capital structure.
  • Use averages of comparable companies' capital structures as the target capital structure.