The weighted average cost of capital (WACC) is an important measurement for any business. The most important components involve the sources of capital, component costs, flotation cost adjustments, and risk adjustments (Horngren, Harrison Jr., & Oliver, 2011). Most commonly, capital comes from debt and equity. Specifically, capital can be obtained from long-term debt (such as notes payable), preferred stock, and common equity (such as retained earnings and common stock). The formula for WACC is (Horngren et al., 2011):
Within this formula, refers to the company’s weight of debt, whereas refers to the company’s cost of debt. refers to the company’s weight of preferred stock, whereas refers to the company’s cost of preferred stock. refers to the company’s weight of common stock, whereas refers to the company’s cost of common stock. refers to the company’s tax rate.
WACC provides a rate of return to its investors. Most companies have a set minimum WACC and in order for the project to be accepted, the WACC must be above this rate (Horngren et al., 2011). Thus, the WACC shows how much must be returned to the stakeholders through their investment. This means that WACC is a valuation tool for most companies. Therefore, it is beneficial for stakeholders to focus on after-tax cost of capital components. This means that the WACC calculation needs to be based on after-tax costs. However, cost of debt may need to be adjusted as interest expenses are typically tax deductible. Moreover, cost of capital will need to be based on marginal costs, not historical costs. This is because WACC is based on raising new capital, which may not have the same value due to inflation and other factors (Horngren et al., 2011).
The weights may be book value or market value. When the book value is used, there are commonly higher debt percentages. For cost of debt weights, it is common for companies to utilize the yield to maturity on outstanding long-term debt. The cost of tax is considered because interest expenses are tax deductible. If the flotation costs are small, they are typically ignored. When considering cost of preferred stock, no tax adjustment is needed. Therefore, the nominal rate for the cost of preferred stock is utilized (Horngren et al., 2011). This marginal cost refers to the required rate of return by investors on preferred stock investments. However, it is also evident that preferred stock is riskier because the company is not required to pay dividends on preferred stock. In most cases, companies will try to pay this dividend because otherwise, common stock dividends cannot be paid, funds will be difficult to raise, and/or the preferred stockholders may gain control of the company. In most cases, the yield on preferred stock will be lower than on long-term debt. This is because many corporations own most of preferred stock – up to 70% in most cases (Horngren et al., 2011). The higher after-tax yield on preferred stock is because the portion of preferred stock is tax deductible, as well as the higher after-tax cost of preferred cost is consistent with increasing risk that exists on preferred stock. Common stock also has a particular rate of return. Commonly, this involves the use of retained earnings. This is because retained earnings can be reinvested into the company or paid out as dividends. At the same time, it is noted that investors have the opportunity to purchase other securities, as well as earn a return through other methods (Horngren et al., 2011). Through retaining earnings, the company gains an opportunity cost, whereby investors may purchase similar stocks or the company may repurchase its own stock. Either option raises capital for the company.
The cost of common stock weight can be determined through CAPM, DCF, or bond-yield-plus-risk-premium methods. Growth can be calculated with DCF, even if the growth is not constant. However, this could increase complexity in calculation. It is also evident that the bond-yield-plus-risk-premium method is best used as a check to one of the other methods to ensure that the ballpark range is accurate for the cost of common stock weight (Horngren et al., 2011). When using all three methods, a range can be found. It would be viable to use the midpoint of this range. The average could also be used, provided there are not any outliers (meaning the numbers need to be similar). Retained earnings costs are cheaper than common stock costs because flotation costs must be paid when issuing common stock. At the same time, through the issuance of common stock may suggest a negative shock within capital markets, prompting the stock price of the company to decrease (Horngren et al., 2011). Flotation costs can be adjusted through being included in upfront costs, which would reduce overall return, or incorporate the flotation cost in the DCF model. Flotation costs are dependent upon the risk and capital type to be raised and are most likely to be highest for common equity (Horngren et al., 2011).
WACC is beneficial for the company for a variety of reasons. Most importantly, it ensures that the company will earn the return to satisfy multiple facets of the company, such as equity and debt. This information is useful to the company in that it allows investors and decision-makers to ensure that the project is viable for the company as a whole. This can result in increased satisfaction with the investment as a whole.
- Horngren, C. T., Harrison Jr., W. T., & Oliver, M. S. (2011). Financial & Managerial Accounting (3rd ed.). Pearson Education, Inc.