8.2 Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital (WACC) is a crucial financial metric that blends the costs of a company's various funding sources. It's the minimum return a firm must earn on investments to satisfy all capital providers, balancing debt's tax benefits with equity's flexibility.

WACC calculation involves weighing each capital source by its market value proportion. It's used as a benchmark for investment decisions, helping companies determine if projects will create or destroy value. The optimal capital structure minimizes WACC, maximizing firm value.

Weighted Average Cost of Capital (WACC)

Weighted average cost of capital

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• Represents the overall cost of financing for a company by considering the costs of all sources of capital (debt, preferred stock, and common equity)
• Calculated by weighting each source of capital by its proportion in the capital structure based on market values, not book values
• Expressed as a percentage or rate and represents the minimum rate of return a company must earn on its investments to satisfy all capital providers (creditors and shareholders)

Calculation of WACC components

• WACC formula: $WACC = w_d r_d (1-t) + w_p r_p + w_e r_e$
  • $w_d$, $w_p$, and $w_e$ are the weights of debt, preferred stock, and common equity, respectively
  • $r_d$, $r_p$, and $r_e$ are the costs of debt, preferred stock, and common equity, respectively
  • $t$ is the corporate tax rate
• Calculate weights by determining market values of debt, preferred stock, and common equity and dividing each component by total market value of firm's capital
• Cost of debt ($r_d$) is yield to maturity on company's debt, adjusted for tax deductibility of interest payments using $(1-t)$
• Cost of preferred stock ($r_p$) is preferred dividend divided by market price of preferred stock
• Cost of common equity ($r_e$) can be estimated using Capital Asset Pricing Model (CAPM) or Dividend Growth Model (DGM)

WACC as minimum return requirement

• Represents opportunity cost of investing in a company as investors expect to earn a return that compensates them for the risk they take
• Companies should only invest in projects that offer a return higher than WACC to avoid destroying shareholder value
• Used as discount rate for evaluating investment opportunities to determine ###Net_Present_Value_(NPV)0### and ###Internal_Rate_of_Return(IRR)_0### of projects

Capital structure vs WACC

• Capital structure refers to mix of debt and equity financing used by a company
• Changes in capital structure can affect WACC:
  1. Increasing debt proportion initially lowers WACC due to tax benefits and lower cost of debt, but excessive debt increases financial risk and cost of equity, leading to higher WACC
  2. Increasing equity proportion reduces financial risk but may increase WACC due to higher cost of equity
• Optimal capital structure minimizes WACC by balancing benefits and costs of debt and equity financing to maximize firm value by minimizing cost of financing