Weighted average cost of capital

In general, the WACC can be calculated with the following formula: \text{WACC} = \frac{\sum_{i=1}^N r_i \cdot MV_i }{\sum_{i=1}^N MV_i} where N is the number of sources of capital (securities, types of liabilities); r_i is the required rate of return for security i; and MV_i is the market value of all outstanding securities i. In the case where the company is financed with only equity and debt, the average cost of capital is computed as follows: \text{WACC} = \frac{D}{D+E}K_d + \frac{E}{D+E}K_e where D is the total debt, E is the total shareholder's equity, K_d is the cost of debt, and K_e is the cost of equity. The market values of debt and equity should be used when computing the weights in the WACC formula. Tax effects 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 MV_e and cost of equity R_e and one type of bonds with the total market value of MV_d and cost of debt R_d, in a country with corporate tax rate t, is calculated as: \text{WACC} = \frac{MV_e}{MV_d+MV_e} \cdot R_e + \frac{MV_d}{MV_d+MV_e} \cdot R_d \cdot (1-t) This calculation can vary significantly due to the existence of many plausible proxies for each element. As a result, a fairly wide range of values for the WACC of a given firm in a given year may appear defensible. == Components ==

Debt ''The firm's debt component is stated as kd'' and since there is a tax benefit from interest payments then the after tax WACC component is kd(1-T); where T is the tax rate. Increasing the debt component under WACC has advantages including: • no loss of control (voting rights), • interest expense is tax deductible. But there are also disadvantages including: • legal obligation to make payments, • taking on more debt increases financial risk. Equity The weighted average cost of capital equation including preferred stock is: :\text{WACC} = w_d \cdot [K_d(1-t)] + w_{pf} \cdot K_{pf} + w_{ce} \cdot K_{ce} When issuing new common equity, the cost must be adjusted for underwriting fees, termed flotation costs (F). The adjusted cost of equity (K_e) is calculated as: :K_e = \frac{D_1}{P_0(1-F)} + g where: • D_1 is the expected dividend, • P_0 is the current stock price, • F is the flotation cost percentage, • g is the dividend growth rate. There are 3 ways of calculating Ke: • Capital Asset Pricing Model • Dividend Discount Method • Bond Yield Plus Risk Premium Approach The equity component has advantages for the firm including: • no legal obligation to pay (depends on class of shares) as opposed to debt, • no maturity (unlike e.g. bonds), • lower financial risk, and • it could be cheaper than debt with good prospects of profitability. But also disadvantages including: • new equity dilutes current ownership share of profits and voting rights (impacting control), • cost of underwriting for equity is much higher than for debt, • too much equity makes it a target for a leveraged buyout by another firm, and • no tax shield, dividends are not tax deductible, and may exhibit double taxation. ==Marginal cost of capital schedule==

Marginal cost of capital (MCC) schedule or an investment opportunity curve is a graph that relates the firm's weighted cost of each unit of capital to the total amount of new capital raised. The first step in preparing the MCC schedule is to rank the projects using internal rate of return (IRR). The higher the IRR the better off a project is. == Enterprise valuation (WACC approach) ==

The WACC approach is the most widely used variant of the discounted cash flow (DCF) method. Under this "entity approach," the firm is conceptually separated into an operating area (Operating Free Cash Flow) and a financing area. Assuming an infinite corporate lifespan, the market value of the enterprise—including the market value of non-operating assets N_0—is determined by the following formula: :\text{Enterprise Value} = \sum_{t=1}^{\infty} \frac{OFCF_t}{(1 + WACC_t)^t} + N_0 The Operating Free Cash Flow (OFCF) represents the cash surplus available as if the company were entirely equity-financed. The tax shield from debt is accounted for by reducing the WACC (the discount rate). Consequently, the firm's actual capital structure is reflected in the denominator rather than the numerator. Contrary to common belief, the WACC method does not strictly require a constant capital structure. However, if the leverage ratio changes over time, the WACC must be adjusted using the Miles-Ezzell adjustment formula. The Modigliani-Miller adjustment formula is generally not applicable here as it assumes a constant absolute amount of debt (autonomous financing), which contradicts market-value-oriented financing where debt levels are adjusted to keep pace with the company's valuation. ==See also==