Weighted average cost of capital
(WACC).
1.
The average cost of capital of a firm, taking into account:
(1) All sources of capital
(2) Weighted by their current market values.
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.
Examples
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]
= 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.
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%
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:
= 10% x 0.25 + 3.6% x 0.75
= 2.5% + 2.7%
= 5.2%
However, the simple 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.
2.
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
(2) Of more than the WACC - of, for example in the first case above, 6.8%.
See also
