Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 21

Weighted Average Cost of Capital¹

Introduction

Where Does WACC Come From?

When to Use WACC

Valuing the Levered Business Enterprise

After-Tax WACC

Debt Capacity and Optimal Capital Structure

Computing WACC for a Public Company

Income Tax Rates Impact WACC

Market Value of Debt

Computing WACC for a Nonpublic Company

Should an Actual or a Hypothetical Capital Structure Be Used?

Should a Constant or Variable Capital Structure Be Used?

Fixed Book-Value Leverage Ratio

Pre-Interest-Tax-Shield WACC

Capital Cash Flows

Equivalence of Valuation Methodologies

Other Tax Shields

Summary

Additional Reading

Appendix 21A: Iterative Process Using CAPM to Calculate the Cost of Equity Component of the Weighted Average Cost of Capital

INTRODUCTION

In Chapter 20, we identified components of a company's capital structure. To estimate the weighted cost for all of the company's overall capital, we blend their costs together to derive the company's weighted average cost of capital (WACC), often called the overall cost of capital. In other words, we want to estimate the weighted cost for all of the company's invested capital. This requires a discussion of the appropriate amount of debt and equity in the capital structure and how much value, if any, the debt adds to the value of the providers of equity capital because of the interest tax shield that we discuss later in this chapter.

The most common assumptions made by analysts are that (1) the market value of debt capital equals its face value ...