Weighted average cost of capital: Difference between revisions
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(WACC). | (WACC). | ||
1. | |||
'''1.''' | |||
The average cost of capital of a firm, taking into account all sources of capital, weighted by their current market values. | The average cost of capital of a firm, taking into account all sources of capital, weighted by their current market values. | ||
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: | ||
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] | ||
Where: | Where: | ||
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. | ||
D = market value of debt. | D = market value of debt. | ||
'''''Example''''' | |||
For example where: | For example 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 | ||
D = market value of debt = $100m | D = market value of debt = $100m | ||
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=200] + 3.6% x 100/[100+100=200] | = 10% x 100/[100+100=200] + 3.6% x 100/[100+100=200] | ||
= 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 example. | 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 example. | ||
2. | |||
'''2.''' | |||
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 6.8%. | 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 6.8%. | ||
== See also == | == See also == | ||
| Line 35: | Line 60: | ||
* [[Optimal capital structure]] | * [[Optimal capital structure]] | ||
* [[Shareholder value]] | * [[Shareholder value]] | ||
Revision as of 16:48, 11 June 2013
(WACC).
1.
The average cost of capital of a firm, taking into account all sources of capital, weighted by their current market values.
For a firm with both equity and debt capital, the WACC would be calculated as:
WACC = 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
For example 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=200] + 3.6% x 100/[100+100=200]
= 5% + 1.8%
= 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 example.
2.
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 6.8%.
