Weighted average cost of capital
Encyclopedia
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets.
The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere. Companies raise money from a number of sources: common equity
, preferred equity, straight debt
, convertible debt, exchangeable debt, warrants
, options
, pension liabilities
, executive stock options, governmental subsidies, and so on. Different securities, which represent different sources of finance, are expected to generate different returns. The WACC is calculated taking into account the relative weights of each component of the capital structure
. The more complex the company's capital structure, the more laborious it is to calculate the WACC.
Companies can use WACC to see if the investment projects available to them are worthwhile to undertake.
where
is the number of sources of capital (securities, types of liabilities); 
is the required rate of return for security 
; 
is the market value of all outstanding securities 
.
Tax effects can be incorporated into this formula. For example, the WACC for a company financed by one type of shares with the total market value of
and cost of equity 
and one type of bonds with the total market value of 
and cost of debt 
, in a country with corporate tax rate 
is calculated as:
The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere. Companies raise money from a number of sources: common equity
Common equity
-Basel III:Under the new Basel III banking agreement large internationally active banks will be required to hold a minimum of 7% of their assets in common equity.This regulation is to be fully effective as of 1 Jan 2019.-Sources:...
, preferred equity, straight debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
, convertible debt, exchangeable debt, warrants
Warrant (finance)
In finance, a warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiry date....
, options
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
, pension liabilities
Pension
In general, a pension is an arrangement to provide people with an income when they are no longer earning a regular income from employment. Pensions should not be confused with severance pay; the former is paid in regular installments, while the latter is paid in one lump sum.The terms retirement...
, executive stock options, governmental subsidies, and so on. Different securities, which represent different sources of finance, are expected to generate different returns. The WACC is calculated taking into account the relative weights of each component of the capital structure
Capital structure
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
. The more complex the company's capital structure, the more laborious it is to calculate the WACC.
Companies can use WACC to see if the investment projects available to them are worthwhile to undertake.
Calculation
In general, the WACC can be calculated with the following formula:where
is the number of sources of capital (securities, types of liabilities); is the required rate of return for security ; is the market value of all outstanding securities .Tax effects can be incorporated into this formula. For example, the WACC for a company financed by one type of shares with the total market value of
and cost of equity and one type of bonds with the total market value of and cost of debt , in a country with corporate tax rate is calculated as:See also
- Beta coefficientBeta coefficientIn finance, the Beta of a stock or portfolio is a number describing the relation of its returns with those of the financial market as a whole.An asset has a Beta of zero if its returns change independently of changes in the market's returns...
- Cost of capitalCost of capitalThe cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds , or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities"...
- Discounted cash flowDiscounted cash flowIn finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...
- Economic Value AddedEconomic value addedIn corporate finance, Economic Value Added or EVA, a registered trademark of Stern Stewart & Co., is an estimate of a firm's economic profit – being the value created in excess of the required return of the company's investors . Quite simply, EVA is the profit earned by the firm less the cost of...
- Internal rate of returnInternal rate of returnThe internal rate of return is a rate of return used in capital budgeting to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return or the rate of return . In the context of savings and loans the IRR is also called the effective interest rate...
- Minimum acceptable rate of returnMinimum acceptable rate of returnIn business and engineering, the minimum acceptable rate of return, often abbreviated MARR, or hurdle rate is the minimum rate of return on a project a manager or company is willing to accept before starting a project, given its risk and the opportunity cost of forgoing other projects...
- Modigliani-Miller theoremModigliani-Miller theoremThe Modigliani–Miller theorem forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process , in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is...
- Net present valueNet present valueIn finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...
- Opportunity costOpportunity costOpportunity cost is the cost of any activity measured in terms of the value of the best alternative that is not chosen . It is the sacrifice related to the second best choice available to someone, or group, who has picked among several mutually exclusive choices. The opportunity cost is also the...
External links
- Video about practical application of the WACC approach
- Velez-Pareja, Ignacio and Tham, Joseph, "A Note on the Weighted Average Cost of Capital WACC" (August 7, 2005). Available at SSRN: http://ssrn.com/abstract=254587. Unpublished.
- Cheremushkin, Sergei Vasilievich, How to Avoid Mistakes in Valuation - Comment to 'Consistency in Valuation: A Practical Guide' by Velez-Pareja and Burbano-Perez and Some Pedagogical Notes on Valuation and Costs of Capital (December 21, 2009). http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1526681. Unpublished.
- WACC calculator
- A more realistic valuation: APV and WACC with constant book leverage ratio
- calculate the WACC with your own values to understand the equation
- Find the WACC of any publicly traded company by entering the firm's stock ticker symbol
- Paper describing a method for generating the WACC curve when there is default risk - spreadsheet available