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# WACC

last edited by 10 years, 1 month ago

# What is the cost of different capital sources:

The rate of return that an equity investors expects is (of course) higher than that of a debt financer.  This makes sense:  a banker that lends you money under strict terms, and expects payments every month in interest (perhaps with assets such as inventory as security) should feel safer, and demand less of a return on his investment than an equity investor that will only profit if the business is a success.

Based on this logic:  equity capital should be the most "expensive", and debt capital should be the least expensive

## Investing 101

There is a relationship between risk and expected return.  The more you want in returns, the more risk you need to be willing to take.  But, that said...there is an expected amount of risk for any return.  Risking too much is not a sign of bravery, its a sign of stupidity.   When looking at risk and returns, you should understand the CAPM - Capital Asset Pricing Model - to estimate the cost of equity .  Within this model, you should use the T-bills rate of return as the "risk-free" rate, and then add a risk-premium.

## Different Cost levels of Capital (vary with risk of investor) # WACC definition

The weighted average cost of capital (WACC) is used in finance to measure a firm's cost of capital. This has been used by many firms in the past as a Discount rate for financed projects, as the cost of financing (capital) is regarded by some as a logical discount rate (required rate of return) to use. Weighted Average Cost of Capital is the return a firm must earn on existing assets to keep its stock price constant and satisfy its creditors and owners.

Note:  the expected return to the investor is the cost of capital to the firm, so the cost of capital is positively related to the beta coefficient. The cost of capital is also tied to the liquidity of the asset.  The less liquid the asset (stock, project, etc), the higher the expected cost of capital.  The Discount rate will therefore be higher, and when making capital budgeting decisions (i.e. deciding whether or not to invest in a project, or company) the higher the discount rate, the fewer new projects that will be taken on.  This is whey risk is important to the entrepreneur, because it defines how expensive it is for them to raise money.

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:

WACC = wd (1-T) rd + we re

wd = debt portion of equity
T = tax rate
rd = cost of debt (rate)
we = internal equity portion of equity
re = cost of internal equity (rate) $c=left( {E over K} right) cdot y + left( {D over K} right) cdot b (1-{t_C over 100})$

where $K=D + E$

and the following table defines each symbol:

Symbol Meaning Units $c$ weighted average cost of capital  % $y$ required or expected rate of return on equity, or cost of equity  % $b$ required or expected rate of return on borrowings, or cost of debt  % $t_C$ corporate tax rate  % $D$ total debt and leases (including current portion of long-term debt and notes payable) currency $E$ total market value of equity and equity equivalents currency $K$ total capital invested in the going concern currency

Definition from wikipedia