A note on the weighted average cost of capital: for advanced management accounting students

A note on the weighted average cost of capital: for advanced management accounting students

 

In the context of advanced management accounting study, highlight 4 main ideas on the topic of weighted average cost of capital and provide a simple example of how to calculate it.

 

Weighted average cost of capital (WACC) is the blended, after-tax cost of financing a firm through debt, equity, and—where relevant—preferred shares. It is widely used as a discount rate for investment appraisal and value-based management.

Four main ideas

1.    WACC is a weighted average, not a simple average. Each source of finance is multiplied by its proportion of total capital, so a firm that is mostly equity-funded will have a WACC closer to its cost of equity.

2.    Debt has a tax shield. Interest is usually tax-deductible, so the relevant cost of debt is the after-tax cost: rd(1−T). Equity does not receive this adjustment.

3.    Use market values and appropriate component costs. In practice, WACC normally uses the market value of equity and debt to determine weights, while the cost of equity may be estimated using models such as CAPM.

4.    WACC is a benchmark for value creation. A project should generally be accepted only if its expected return exceeds the WACC; if the return is below WACC, the investment is not earning enough to satisfy providers of capital.

Formula

For a firm financed only by debt and equity:

WACC=(E/V×re)+(D/V×rd×(1−T))

where E is market value of equity, D is market value of debt, V=E+D 

re​ is cost of equity, rd  is pre-tax cost of debt, and T is the tax rate.

Simple example

A company has:

• Equity: HK$4 million, with a cost of equity of 10%
• Debt: HK$1 million, with a pre-tax cost of debt of 5%
• Corporate tax rate: 25%

Total capital is HK$5 million, so equity is 80% and debt is 20% of the capital structure.

WACC=(0.80×10%)+(0.20×5%×(1−0.25)

WACC=8%+0.75%=8.75%

The company’s WACC is 8.75%. Therefore, a new project with similar risk should ideally generate a return above 8.75% to add value for shareholders and lenders.