Weighted average cost of capital
/What is the Weighted Average Cost of Capital?
The weighted average cost of capital (WACC) is a compilation of the aggregate financing costs of a business. In this calculation, each element of the firm’s financing cost is proportionately represented. All sources of capital are used in the calculation, including bonds, short-term and long-term notes, common stock, and preferred stock. The WACC is used to discount the cash flows associated with capital budgeting proposals to determine their net present values. The components of the cost of capital are common stock, preferred stock, and debt.
The WACC tends to decrease as a percentage when a business uses a higher proportion of debt as its source of funding, since the related interest expense is tax deductible, which reduces the cost of this form of funding. However, if too much debt is used, lenders will raise the interest rates charged, which increases the WACC. Consequently, there is a "sweet spot" where a business can take on an optimal amount of debt burden.
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Example of the Weighted Average Cost of Capital
The following table shows a derivation of the weighted average cost of capital, where the outstanding amount of each funding source is multiplied by its related cost, to arrive at an aggregate cost percentage for all sources of revenue. Note that the weighted average of the various elements of the cost of capital in the sample calculation is 12%, which would then be used for the analysis of proposed investments.
Inclusion of a Risk Premium
When evaluating an investment proposal, the net present value calculation should only use the WACC to discount the associated cash flows if the risk profile of the investment is approximately the same as that of the firm. If the investment is more risky, then a risk premium should be added to the WACC and then used as the discount rate.
Problems with the Weighted Average Cost of Capital
While the weighted average cost of capital can be quite useful, you should be aware of some problems with it. They are as follows:
Difficult to calculate. The cost of equity component of the calculation can be difficult to determine. It is derived from the rate of return for the general market, the beta value of the stock, and the current risk-free rate. All three of these values can vary somewhat by day, so the cost of equity can be considered a moving target.
Assumes a constant capital structure. There is an inherent assumption that a business will maintain a constant capital structure (the proportion of debt and equity) over time. In reality, companies may change their mix of debt and equity due to market conditions, growth stages, or internal strategies. A variable capital structure can render WACC less reliable as a discount rate.
Subject to market volatility. Market-based parameters, such as equity beta or market risk premium, fluctuate frequently, leading to variability in WACC calculations. This volatility may result in inconsistent valuations.
Tax shield assumption. WACC includes the benefit of the tax shield from interest payments on debt. However, changes in tax policy can make the tax shield unpredictable. Also, it assumes the company can always benefit from this shield, which may not be true if profits are insufficient to fully use tax-deductible interest.
Encourages use of debt. Since debt financing is generally cheaper due to tax shields, WACC may incentivize an excessive level of debt usage, which increases the risk of bankruptcy - especially during economic downturns.