10.2 Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital (WACC) is a crucial metric in finance. It represents the average cost of financing a company's operations through debt and equity. Understanding WACC is essential for making informed decisions about capital structure and investment projects.

Calculating WACC involves determining the costs of debt and equity, as well as their respective weights in the capital structure. This section covers the WACC formula, target capital structures, after-tax cost of debt, and the concept of marginal WACC for evaluating new investments.

WACC Calculation

WACC Formula and Weights

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• WACC represents the weighted average cost of a company's capital sources including debt and equity
• WACC formula: $WACC = (E/V) * R_E + (D/V) * R_D * (1-T_C)$
  • $E$ is the market value of equity
  • $D$ is the market value of debt
  • $V$ is the total market value of the firm's financing $(E+D)$
  • $R_E$ is the cost of equity
  • $R_D$ is the cost of debt
  • $T_C$ is the corporate tax rate
• Market value weights reflect the current market values of debt and equity capital
  • Provides the most accurate representation of a company's true capital structure
  • Calculated using the current stock price and outstanding shares for equity and market yield and par value for debt
• Book value weights use the accounting values of debt and equity from the balance sheet
  • Does not reflect current market conditions or the true economic cost of capital
  • Can be used as an approximation when market values are not readily available (private companies)

Target Capital Structure

• The target capital structure is the ideal mix of debt and equity financing a company aims to maintain over the long term
• Represents the optimal balance that minimizes WACC and maximizes firm value
• Managers estimate the target based on industry benchmarks, credit ratings, and financial flexibility considerations
• WACC should be calculated using the target weights rather than current market weights
  • Ensures consistency with the company's long-term financing strategy
  • Avoids short-term fluctuations in market values that may not align with the target

Cost of Debt

Calculating the After-Tax Cost of Debt

• The cost of debt is the effective rate a company pays on its debt financing
• Calculated as the yield to maturity on the company's outstanding bonds
  • Represents the market's required return for lending to the firm
  • Incorporates the risk of default and the time value of money
• Must be adjusted for taxes to reflect the deductibility of interest expenses
  • Interest payments reduce taxable income, providing a tax shield
  • After-tax cost of debt: $R_D * (1-T_C)$
• Example: If a company's pre-tax cost of debt is 6% and its marginal tax rate is 25%, the after-tax cost of debt would be 6% * (1-0.25) = 4.5%

Flotation Costs and the Cost of Debt

• Flotation costs are the fees and expenses associated with issuing new debt securities (underwriting fees, legal fees, etc.)
• These costs increase the effective cost of debt financing beyond the stated coupon rate
• Can be incorporated into the cost of debt calculation by amortizing them over the life of the bond issue
  • Treat flotation costs as an upfront cash outflow and solve for the YTM that equates the net proceeds to the PV of future cash flows
• Ignoring flotation costs may understate the true cost of debt and lead to suboptimal financing decisions

Marginal WACC

Calculating and Applying the Marginal WACC

• Marginal WACC is the cost of raising an additional dollar of capital at the margin
• Reflects the specific costs and proportions of debt and equity used for the incremental financing
  • May differ from the firm's overall WACC if the new financing mix deviates from the target capital structure
• Calculated using the same WACC formula but with the marginal weights and costs of the new debt and equity
• Used for evaluating new investment projects or acquisitions
  • Ensures that the discount rate reflects the specific financing costs associated with the incremental capital
  • Avoids over- or under-stating the project's NPV by using the firm's average WACC
• Example: If a company plans to fund a new project with 40% debt at 5% and 60% equity at 10%, the marginal WACC would be (0.60 * 10%) + (0.40 * 5% * (1-0.25)) = 7.5%