Weighted average cost of capital: Difference between revisions

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(WACC).  
(WACC).  


'''1.'''
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 average cost of capital of a firm, taking into account:
 
The WACC is the average cost of capital of a firm, taking into account:


(1) All sources of capital
(1) All sources of capital
Line 9: Line 12:
(2) Weighted by their current market values.
(2) Weighted by their current market values.


==WACC calculations==


For a firm with both equity and debt capital, the WACC would be calculated as:
For a firm with both equity and debt capital, the WACC would be calculated as:
Line 15: Line 20:
WACC = Ke x ''proportion of equity'' + Kd(1-t) x ''proportion of debt''
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]
= Ke x E/(D + E)  + Kd(1 - t) x D/(D + E)




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Ke = cost of equity.
Ke = cost of equity.


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


E = market value of equity.
E = market value of equity.
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'''''Examples'''''
<span style="color:#4B0082">'''Example 1: Equal equity and debt'''</span>


For example where:
Where:


Ke = cost of equity = 10%
Ke = cost of equity = 10%


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


E = market value of equity = $100m
E = market value of equity = $100m
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WACC = Ke x E/[D+E] + Kd(1-t) x D/[D+E]
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/[100+100=200] + 3.6% x 100/[100+100=200]
= 10 x 100/200 + 3.6 x 100/200  


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


= 5% + 1.8%
= 5 + 1.8


= '''6.8%'''
= '''6.8%'''




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


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:
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
= 10 x 0.75 + 3.6 x 0.25


= 7.5% + 0.9%
= 7.5 + 0.9


= '''8.4%'''
= '''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%, the WACC might in theory fall to:
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
= 10 x 0.25 + 3.6 x 0.75


= 2.5% + 2.7%
= 2.5 + 2.7


= '''5.2%'''
= '''5.2%'''




However, the simple 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.
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.




'''2.'''
==Creating shareholder value==


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


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


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




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

Latest revision as of 06:02, 3 July 2021

(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.


Example 1: Equal equity and debt

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.


Example 2: Increasing equity, reducing debt

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%


Example 3: Reducing equity, increasing debt

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 more than the WACC - of, for example in Example 1 above, 6.8%.


See also


Other resources

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