Weighted average cost of capital

Weighted Average Cost of Capital ( WACC) ( German weighted average cost of capital ) means a belonging to the discounted cash flow method of business valuation approach. The method is often referred to as free cash flow method. The weighted average cost of capital is used by many companies to determine the minimum rate of return for investment projects. For the plausibility of calculating a gross method ( entity approach ) must be applied. Here, the free cash flows and the total cash flow to be discounted.

Overview

The economists Merton Miller and Franco Modigliani have shown in their Modigliani -Miller theorem that in a perfect economy is independent of the level of debt without tax value of the company. But many governments allow a deduction of interest on borrowings of the tax base, this creates a tendency to finance.

The purpose of the discounted cash flow method is an exact (quantitative) determination of the tax Vantage from a pro-rata debt financing. So the amount of the tax Vantage depends on the financing policy of the company. In many cases, only a corporate tax (ie, for example, a corporation or business tax ) even if such a taxation of the shareholders is neglected.

If now further assumed that the company operates a so-called (market ) value-based financing ( with a market value-based financing is already the future debt ratio, ie the ratio of debt to equity value, given exactly in the entire future, deviations or other uncertainties are excluded ), then offers the use of the WACC approach ( Weighted Average cost of Capital). If one uses for the company valuation using deterministic WACC in each period ( which is usually assumed for simplicity), this corresponds to the assumption of a market- value-based funding - the company is, however, not financed market- value-based, then the correct value of the company is not consistent with the WACC value.

In addition to the WACC approach, one can also use the TCF or the RTD approach. All three methods lead to the same value of the company. Which of the three methods to use depends on which information has the evaluator. In the WACC method it is assumed that the evaluator knows the expected cash flows of the company and also involuntary, the weighted cost of capital of the indebted enterprise. Both the RTD as well as the TCF process make different assumptions with respect to this information.

Calculation of WACC

WACC are weighted cost of capital. It is calculated as a weighted average cost of equity and cost of debt, the cost of debt should be reduced by the tax benefit:

In which

Using the following symbols:

This equation describes the situation with homogeneous equity and debt capital. If the capital is heterogeneous (eg additional preferred share capital, registered shares with a par value others, etc.) the formula must be expanded.

Value of the indebted enterprise

With:

  • Value of the indebted enterprise
  • Weighted cost of capital of the indebted enterprise at time t
  • Expected cash flows from the undeserved company at time t

The WACC method is (contrary to popular belief ) is not the constancy of the capital structure ahead. The weighted cost of capital can be calculated only with the adjustment formula of Miles - Ezzell. The Modigliani -Miller adjustment formula is not applicable because this constant borrowing assumes that an autonomous financing policy means and means a contradiction to the market- value-based financing. The Modigliani -Miller theorem remains valid.

Links and literature

  • Scientific literature on WACC and business valuation
  • Video on practical application of the WACC method
  • Tom Copeland, Tim Koller, Jack Murrin: enterprise value. Methods and strategies for value- oriented corporate management. 3rd completely revised and expanded edition. Campus -Verlag, Frankfurt am Main, inter alia, 2002, ISBN 3-593-36895-1.
Modigliani–Miller theorem Capital Asset Pricing Model
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