How does a company with debt, preferred stock, and common stock in its target capital structure calculate its weighted average cost of capital (WACC)?
WACC = wd rd(1-T) + wp rp + wcrs
rd=marginal debt capital
rp=marginal preferred stock
rs=marginal cost of common equity using retained earnings
The weighted average cost of capital (WACC) is calculated using the following formula: WACC = wdrd(1 – T) + wpsrps + wsrs, where wd is the percent of debt, rd is the interest rate on the firm’s new debt, T is the firm’s marginal tax rate, wps is the percent of preferred stock, rps is the yield investors expect on the preferred stock, ws is the percent of common equity (common stock), and rs is the rate of return investors expect from the firm’s common stock. The proportions of debt, preferred stock and common equity typically used in the formula are the target proportions to eliminate slight variability due to slight actual differences from the target proportions.
How is the weighted average cost of capital (WACC) used in a capital investment program to select investments?
The weighted average cost of capital (WACC) is a tool used to decide whether or not to invest. It represents the minimum rate of return at which a company produces value for its investors. If the companies return is more than the WACC than for each dollar the company invests it is creating value. Conversely if the company’s return is less than the WACC the company is shedding value and that investors should go in a different direction. Ultimately the WACC can serve as a solid indicator for investors but is not necessarily a commonly used tool because it requires detailed information about the company that may be difficult to acquire.
“The capital funding of a company is made up of two components: debt and equity. Lenders and equity holders each expect a certain return on the funds or capital they have provided. The cost of capital is the expected return to equity owners (or shareholders) and to debt holders, so WACC tells us the return that both stakeholders – equity owners and lenders – can expect. WACC, in other words, represents the investor’s opportunity cost of taking on the risk of putting money into a company.”
WACC is the sum of the cost of debt and the cost of equity. It is based on market values not book values and is based on management’s target capital goals. Because it is based on target, it is not explicit costs. This is the opportunity costs of raising a new dollar of capital; a marginal cost. WACC is compared to potential investments. If the projected return on the investment is less than WACC, the investment would reduce stockholder value and should be avoided.
WACC is used to find the required rate of return of the company’s investments. Because WACC is the return required by our investors and is the cost of acquiring the capital, it determines how much we must get back on our investment to make a profit on the investment. So the WACC helps determine the required rate of return on the securities they invest in.
WACC must comprise a weighted-average of the marginal costs of all sources of capital (debt, equity, etc.) since unlevered free cash flows represents cash available to all providers of capital.
WACC = E × re + D × (1 − t) × rd + P × rp
(E+D+P) (E+D+P) (E+D+P)
E = Market value of equity
D = Market value of debt
P = Market value of preferred stock
re = Cost of equity
rd = Cost of debt
rp = Cost of preferred stock
t = Marginal tax rate
The discount rate is a weighted-average of the returns expected by the different classes of capital providers (holders of different types of equity and debt), and must reflect the long-term targeted capital structure as opposed to the current capital structure. While a separate discount rate can be developed for each projection interval to reflect the changing capital structure, the discount rate is usually assumed to remain constant throughout the projection period.
While calculating the weighted-average of the returns expected by various providers of capital, market value weights for each financing element (equity, debt, etc.) must be used, because market values reflect the true economic claim of each type of financing outstanding whereas book values may not change.