Financial Strategy, Advanced Financial Reporting and Risk Management: The Weighted-Average Cost of Capital Is a Useful Formula for Determining Whether an Investment in a Given Venture Is Worth the Risk. It's Also Well-Examined, So Students across the Board Need to Understand It Fully

By Riordan, John B. | Financial Management (UK), December 2014 | Go to article overview

Financial Strategy, Advanced Financial Reporting and Risk Management: The Weighted-Average Cost of Capital Is a Useful Formula for Determining Whether an Investment in a Given Venture Is Worth the Risk. It's Also Well-Examined, So Students across the Board Need to Understand It Fully


Riordan, John B., Financial Management (UK)


The weighted-average cost of capital (WACC) is the minimum return required by a provider of finance for investing in an asset, whether that's a project, a business unit or an entire company. It needs to reflect the capital structure (debt/equity mix) used to finance the investment. Accordingly, it incorporates the "costs" of equity and debt and typically weights these by the market values of the respective instruments in the organisation's capital structure.

Much has been written about the WACC and its components. Here and in subsequent articles I will bring together some of its more prolific aspects in an attempt to help candidates sitting a range of exams under the 2015 syllabus to answer questions involving the WACC with confidence. This is not an attempt to reinvent a well-documented theory. I simply want to give direction and context to that theory. (For the purposes of this article, I'll set aside discussions about the shape of the WACC curve - eg, the traditional view versus that of Merton Miller and Franco Modigliani - as it's clear that any entity's WACC is unlikely to stay constant in perpetuity if only because of the changing nature of the variables within it, let alone the factors affecting those variables.)

On the understanding that the objective is to derive a cost of capital that can be used in making basic investment appraisals, we can rely upon the following WACC formula:

WACC=Keg[Ve/Ve+Vd] + Kd[1 - t] [Vd/Ve + Vd]

For simplicity's sake, the formula assumes two elements in an entity's capital structure - equity and debt - resulting in a simple expression of their respective "costs" after tax specifically and, where possible, weighted by their market values. This can be extended to any number of capital ingredients.

The key is to get the costs and values right in a situation where the "cost" of equity is more akin to an "expected return on equity", while the "cost" of debt will be more akin to an opportunity (as distinct from actual) cost of debt. Note the subtleties creeping in here. Let's explore these further.

The 'cost' of equity (Ike)

As I've mentioned, ke is more typically associated with an expected return on equity - the difference reflecting the fact that shareholders are not assured of a specific - or any - rate of return on their investments. A company does not have to pay dividends or guarantee that its share price will increase. But any failure to deliver to its ordinary shareholders on one or both of these counts in the medium term will make any future fundraising effort - eg, a rights issue - more difficult. Accordingly, it is prudent for a business to work on the assumption that shareholders will have art expected return in mind, clearly depending on the level of risk involved.

A number of approaches may present themselves in the exams as being viable ways to determine the cost of equity. Much will depend on the particular subject you are sitting and the information presented in each case. The most common methods include the following:

* Dividend yield. Given that dividend yields tend to be relatively low - they typically range between 3 and 4 per cent - it's relatively unlikely that you will need to use this approach (dividend per share + share price), but bear it in mind as a last resort. A calculation of dividend per share (DPS) may be required, which at the simplest level will be the declared dividend divided by the number of ordinary shares in issue.

* Dividend growth. The cost of equity emerging from the dividend valuation model is described as the "cost of ordinary (equity) shares, ke, having a current ex-dividend price, Po, having just paid a dividend, do, with the dividend growing in perpetuity by a constant g per cent per annum". Keep this exact language in mind and note that the only difference from what has already been considered in the dividend yield approach is that this one incorporates an expected growth rate in DPS for the foreseeable future: ke = [do [1 + g] + Po) + g. …

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