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Weighted Average Cost of Capital (WACC)

Weighted Average Cost of Capital (WACC), WACC formula with an example, steps in calculations

 

Weighted Average Cost of Capital

Table of Contents

  • Weighted Average Cost of Capital (WACC)
  • What is Weighted Average Cost of Capital (WACC)
  • When to use the Weighted Average Cost of Capital (WACC)
  • WACC formula
  • Steps in WACC calculations
  • Calculation of WACC- Example
  • Selection of weights in WACC
  • Computing WACC for a public company
  • Computing WACC for a private company

Weighted Average Cost of Capital (WACC)

There are different combinations of securities in a company’s capital structure, common equity, preferred equity, and debt. Their different combination leads to variation in the total cost of capital to the company. Once the individual component costs have been calculated, they are multiplied by the proportions of the respective sources of capital to obtain the weighted average cost of capital (WACC). WACC is also known as composite cost of capital, the overall cost of capital. WACC is found by weighting the cost of each specific type of capital by its proportion to the firm’s capital structure.

WHAT IS WACC

Weighted Average Cost of Capital (WACC) is the weighted average after-tax costs of the individual components of a firm’s capital structure. That is, the after-tax cost of each debt and equity is calculated separately and added together to a single overall cost of capital WACC is also known as the overall cost of capital of having capital from different sources. WACC of a company depends on the capital structure of a company. It weighs the cost of capital of a particular source of capital with its proportion to the total capital.

WHEN TO USE THE WEIGHTED AVERAGE COST OF CAPITAL

The most obvious instance in which to use the weighted average cost of capital (WACC) is when the objective is to value the entire capital structure of a company. An example would be when considering an acquisition and the buyer expects to pay off all equity and debt holders and refinance the whole company in a different way that better suits the buyer. Sometimes WACC is also used even when the objective is ultimately to value only the equity. One would value the entire capital structure and then subtract the market value of the debt to estimate the value of the equity. This procedure frequently is used in highly leveraged situations.

The weighted average cost of capital is especially appropriate for project selection in capital budgeting. The proportions of debt and equity that could be available to finance various projects might differ according to the project (e.g., asset-intensive projects may be financed with more debt), and the cost of capital should be based on the specific investment.

WEIGHTED AVERAGE COST OF CAPITAL FORMULA

The weighted average cost of capital is based on the cost of each component net of any corporate-level tax effect of that component. Interest is a tax-deductible expense to a corporate taxpayer. Whatever taxes are paid are an actual cash expense to the company, and the returns available to equity holders are after the payment of corporate-level taxes.

Because we are interested in cash flows after entity-level taxes, we refer to the WACC as an “after-tax WACC.” The basic formula for computing the after-tax WACC for an entity with three capital structure components is:

 

WACC = (Ke × We) + (Kp × Wp) + (Kd(pt)[1 – t] × Wd)

Where:

WACC = Weighted average cost of capital

Ke = Cost of common equity capital

We = Percentage of common equity in the capital structure, at market value

Kp = Cost of preferred equity

Wp = Percentage of preferred equity in the capital structure, at market value

Kd(pt) = Cost of debt (pre-tax)

t = Tax rate

Wd = Percentage of debt in the capital structure, at market value

 

Weighted Average Cost of Capital

STEPS IN WACC CALCULATION

The steps to calculate WACC is as follows:

  1. Estimate the total capital from all the sources.  (i.e. Long term debt capital + Preferred equity + Common Equity Capital + Retained Earnings)
  2. Calculate the proportion (or %) of each source of capital to the total capital.
  3. Multiply the proportion as calculated in Step 2 above with the respective cost of capital.  (i.e. Ke x We- Proportion (%) of equity share capital (for example) calculated in Step 2 above)
  4. Aggregate the cost of capital as calculated in Step 3 above. This is the WACC. (i.e. Ke + Kd + KP + KS as calculated in Step 3 above)

CALCULATION OF WACC- EXAMPLE

Question: From the information given below, calculate the weighted average cost of capital (WACC)

Capital Component

Cost of Capital

% weight on total capital structure

Common equity

11.4% (Ke)

25% (We)

Preferred equity

9.5% (Kp)

15% (Wp)

Long term debt

7.7% (Kd)

60% (Wd)

Answer

Capital Component

Cost of Capital

(A)

% weight on total capital structure

(B)

Total (AxB)

Common equity

11.4% (Ke)

25% (We)

2.85% (Ke x We)

Preferred equity

9.5% (Kp)

15% (Wp)

1.43% (Kp x Wp)

Long term debt

7.7% (Kd)

60% (Wd)

4.62% (Kd x Wd)

Total (WACC)

 

 

8.9%

Selection of weights

There are choice weights between the book value (BV) and market value (MV).

a) Book Value (BV)

Book value weights are operationally easy and convenient.  While using BV, reserves such as share premium and retained profits are included in the BV of equity, in addition to the nominal value of share capital. Here the value of equity will generally not reflect historic asset values, as well as the future prospects of an organisation.

b) Market Value (MV)

The market value approach is theoretically more correct and represents a firm’s capital structure. It is preferable to use MV weights for the equity. While using MV, reserves such as share premium and retained profits are ignored as they are in effect incorporated into the value of equity. It represents existing conditions and also takes into consideration the impacts of changing market conditions and the current prices of various security. Similarly, in the case of debt MV is better to be used rather than the BV of the debt, though the difference may not be very significant.

There is no separate market value for retained earnings. The market value of equity shares represents both paid-up equity capital and retained earnings. But the cost of equity is not the same as the cost of retained earnings. Hence to give market value weights, market value equity shares should be apportioned in the ratio of the book value of paid-up equity capital and the book value of retained earnings.

COMPUTING WACC FOR A PUBLIC COMPANY

For active publicly traded securities, one can compute the weights for each capital component by multiplying the amount of each component outstanding by the market price of each and then computing the percentage that each component represents of the total market value. The five steps for this procedure are:

  1. Identify the number of shares or units of each component of the capital structure.
  2. Determine the market price per unit of each component of the capital structure as of the valuation date.
  3. Multiply the number of units of each component by the market price per unit. This gives the total market value for each capital structure component.
  4. Sum the total market values of each component, from step 3. This gives the market value of invested capital (MVIC).
  5. Divide the total market value of each component (from step 3) by the total MVIC (from step 4). This gives the percentage weight to be accorded to each component of the capital structure.

COMPUTING WACC FOR A PRIVATE COMPANY

The eight steps in the iterative process for estimating capital structure component weights for a closely held company can be summarized in this way:

  1. Estimate the market value of senior securities (debt and preferred equity), and hold that dollar amount fixed throughout the process.
  2. Make a first estimate of the market value weights of the senior securities and the common equity. (Generally, the farther above book value the equity market value is expected to be, the greater the first estimate of the equity percentage compared with its percentage at book value.)
  3. Using the first approximation weights, make a first approximation computation of the WACC.
  4. Project (a) the net cash flows available to all invested capital, and (b) the projected growth rate necessary for either a discounting valuation model or a capitalizing valuation model.
  5. Using the first approximation WACC from step 3 and the projected cash flows from step 4, compute a first approximation market value of invested capital.
  6. Subtract from the MVIC from step 4 the value of the senior securities from step 1. This gives the first approximation value of the common equity.
  7. Compute the capital structure weights using the equity value from step 6.
  8. Repeat the process, starting with step 3, until the computed market value weights come reasonably close to the weights used in computing the WACC.

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