View source for Weighted average cost of capital

(WACC). 

Weighted average cost of capital is used as:
* a discount rate in net present value analysis and
* a hurdle rate in internal rate of return analysis. 


The WACC is the average cost of capital of a firm, taking into account:

(1) All sources of capital

(2) Weighted by their current market values.


==WACC calculations==

For a firm with both equity and debt capital, the WACC would be calculated as:


WACC = Ke x ''proportion of equity'' + Kd(1-t) x ''proportion of debt''

= Ke x E/(D + E)  +  Kd(1 - t) x D/(D + E)


''Where:''

Ke = cost of equity.

Kd(1 -t) = after-tax cost of debt.

E = market value of equity.

D = market value of debt.



<span style="color:#4B0082">'''Example 1: Equal equity and debt'''</span>

Where:

Ke = cost of equity = 10%

Kd(1-t) = after-tax cost of debt = 3.6%

E = market value of equity = $100m

D = market value of debt = $100m


WACC = Ke x E/(D + E)  +  Kd(1 - t) x D/(D + E)

= 10 x 100/(100 + 100) + 3.6 x 100/(100 + 100)

= 10 x 100/200 + 3.6 x 100/200 

= 10 x 1/2 + 3.6 x 1/2

= 5 + 1.8

= '''6.8%'''


This weighted average is exactly mid-way between the cost of equity (10%) and the after-tax cost of debt (3.6%), because the proportions of equity and debt are exactly equal in this first example.


<span style="color:#4B0082">'''Example 2: Increasing equity, reducing debt'''</span>

Making a number of simplifying assumptions, if the proportion of equity were increased to 75% (= 0.75), the proportion of debt would fall to 25% and the WACC might theoretically increase to:

= 10 x 0.75 + 3.6 x 0.25

= 7.5 + 0.9

= '''8.4%'''


<span style="color:#4B0082">'''Example 3: Reducing equity, increasing debt'''</span>

If the firm was 'geared up' to reduce the proportion of equity to 25%, and increase the proportion of debt to 75%, again simplifying, the WACC might in theory fall to:

= 10 x 0.25 + 3.6 x 0.75

= 2.5 + 2.7

= '''5.2%'''


However, the simplified second and third calculations above ignore the change in the ''risk'' to shareholders and to debt holders when the firm's [[capital structure]] is changed in this way.

In practice both the cost of equity and the cost of debt would normally change, following the change in capital structure, leading to a more complex analysis.


==Creating shareholder value==

In order to create or add shareholder value, the managers of this firm would need to earn:

*An after-tax rate of return on their investment projects

*Of <u>more than</u> the WACC - of, for example in Example 1 above, 6.8%.


== See also ==
* [[Adverse selection]]
* [[CertICM]]
* [[Cost of capital]]
* [[Cost of debt]]
* [[Cost of equity]]
* [[Discount rate]]
* [[Economic value added]]
* [[Hurdle rate]]
* [[Internal rate of return]]
* [[Net present value]]
* [[Opportunity cost]]
* [[Optimal capital structure]]
* [[Shareholder value]]


==Other resources==
*[http://www.treasurers.org/node/9023 Treasury essentials: Weighted average cost of capital, The Treasurer, May 2013]
*[[Media:2015_11_Nov_-_Balancing_act.pdf| Balancing act, The Treasurer, 2015]]

[[Category:Corporate_finance]]
[[Category:Long_term_funding]]