Understanding Weighted Average Cost of Capital (WACC) | CFA Level I Corporate Issuers

Today, we’ll dive into the Weighted Average Cost of Capital (WACC) and how to calculate it. We’ll also explore the tax effect on WACC and the principles of assigning weights for WACC calculation. Lastly, we’ll discuss why WACC is also known as the marginal cost of capital.

What is the Weighted Average Cost of Capital (WACC)?

The Weighted Average Cost of Capital (WACC) is the firm’s discount rate used to discount future cash flows for calculating the Net Present Value (NPV) of a project. To determine a meaningful rate, we need to understand the different components of a firm’s capital, which usually consist of debt, equity, and sometimes preferred stock.

Each component represents the required return demanded by investors to compensate them for the risk they take in supplying capital to the company. Typically, the cost of debt is lower than the cost of preferred stock, which is lower than the cost of common equity.

Calculating WACC: Key Components

Let’s define the key components in calculating WACC:

• r_d – Before-tax component cost of debt
• r_p – Cost of preferred stock
• r_e – Cost of common equity

Keep in mind that interest paid on corporate debt is often tax-deductible. As a result, the actual cost of debt to the firm is reduced by the tax savings from the interest paid. This is why we adjust the cost of debt for the firm’s marginal tax rate, by multiplying the term (1-T). This gives us the after-tax cost of debt.

Take note that this tax-deductible adjustment only applies to interest paid on a company’s debt. Dividends to stockholders do not have such treatment, so we do not make the tax adjustments.

WACC Formula and Example

Remember this all-important formula to calculate WACC:

WACC = (W_d x r_d x (1 – T)) + (W_p x r_p) + (W_e x r_e)

Target Capital Structure and WACC

Most firms have a target capital structure, which is the proportions of debt, preferred stock, and equity that the firm aims to achieve over time. The weights in the calculation of WACC should be based on the firm’s target capital structure, not the actual weights. However, a firm’s target capital structure may not always be known to external analysts. In such cases, you can estimate it using the company’s current capital structure based on the market values of the securities or by analyzing trends in the firm’s capital structure.

Alternatively, the analyst may wish to use the industry average capital structure to estimate the target capital structure of the firm.

WACC and Investment Decisions

WACC is an essential factor in making investment decisions. If a project’s return on investment is greater than the WACC, the firm’s value is increased, and such projects should be pursued. Conversely, if the return on investment is less than the WACC, the project should be rejected.

One complication to keep in mind is that a firm’s WACC does not remain constant regardless of the amount it raises. As the firm raises more capital, the risk increases, leading investors to demand higher returns as compensation for the risk. This is illustrated by the marginal cost of capital curve.

Optimal Capital Budget and Investment Opportunity Schedule

(Construction of MCC schedule has been removed from the curriculum. You just need to be aware of what is the MCC curve.)

The intersection of the investment opportunity schedule with the marginal cost of capital curve identifies the optimal capital budget. The intuition here is that the firm should undertake all those projects with Internal Rates of Return (IRRs) greater than the marginal cost of capital. This will maximize the value created. At the same time, no projects with IRRs less than the marginal cost of capital should be undertaken, as they will erode the value created by the firm.

Another way to look at this is that the projects to the left of this intersection should have positive NPV and should be accepted. Conversely, projects to the right should have negative NPV and should be rejected.

Conclusion

In this lesson, we have learned about the Weighted Average Cost of Capital (WACC) of a firm, how to calculate it, and the considerations in determining the weight of each component. In the next lesson, we will learn how to calculate the three component costs of capital.