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The weighted average cost of capital (WACC) is used in finance to measure a firm's cost of capital. It has been used by many firms in the past as a discount rate for financed projects, since the cost of the financing seems like a logical price tag to put on it. Corporations raise money from two main sources: equity and debt. Thus the capital structure of a firm comprises three main components: preferred equity, common equity and debt (typically bonds and notes). The WACC takes into account the relative weights of each component of the capital structure and presents the expected cost of new capital for a firm.
The formula The weighted average cost of capital is defined by: ight) cdot y + left( ight) cdot b (1-t_C ) where and the following table defines each symbol: This equation describes only the situation with homogeneous equity and debt. If part of the capital consists, for example, of preferred stock (with different cost of equity y), then the formula would include an additional term for each additional source of capital. How it works Since we are measuring expected cost of new capital, we should use the market values of the components, rather than their book values (which can be significantly different). In addition, other, more "exotic" sources of financing, such as convertible/callable bonds, convertible preferred stock, etc., would normally be included in the formula if they exist in any significant amounts - since the cost of those financing methods is usually different from the plain vanilla bonds and equity due to their extra features. Sources of information How do we find out the values of the components in the formula for WACC? First let us note that the "weight" of a source of financing is simply the market value of that piece divided by the sum of the values of all the pieces. For example, the weight of common equity in the above formula would be determined as follows: Market value of common equity / (Market value of common equity + Market value of debt + Market value of preferred equity) So, let us proceed in finding the market values of each source of financing (namely the debt, preferred stock, and common stock). Now, let us take care of the costs. WACC = weight of preferred equity × cost of preferred equity + weight of common equity × cost of common equity + weight of debt × cost of debt × (1 − tax rate) And now we are ready to plug all our data into the WACC formula. Effect on valuation The economists Merton Miller and Franco Modigliani showed in the Modigliani-Miller theorem that in a perfect economy without taxes, a firm's cost of capital (and thus the valuation) does not depend on the debt to equity ratio. However, many governments allow a tax deduction on interest and thus in such an environment, there is a bias towards debt financing. See also | ||||||||
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