Weighted Average Cost of Capital
Topic 37 explores the methods of determination of C*, the weighted average cost of capital (WACC). The WACC is the weighted average of the levered cost of equity, CL, and the after-tax cost of debt, i(1 – t), included in the capital structure.
INTRODUCTION TO WEIGHTED AVERAGE COST OF CAPITAL
- Given CU, the unlevered cost of equity from the capital asset pricing model (CAPM), if some level of debt is employed in the capital structure financing mix, a WACC for the debt and equity in the capital structure can be derived that is the basis for the discount rate used in discounted cash flow (DCF) valuations. (The weighted average cost of capital is noted as WACC or k in many works or as C* by Stewart.1)
- The level of debt (expressed as the debt-to-capital ratio, D/C) assumed in the financing mix used to determine C* should reflect a level consistent with:
- The target company's industry characteristics.
- The debt-carrying capacity of the target, not the investor. How much debt is practically financeable in the market?
- Note that the actual anticipated D/C structure of the target is not used for the purpose of determining C* unless such structure equals the target's debt-carrying capacity.
- The reason for this is that the enterprise value of the target should reflect and be based on the amount of debt the market (lenders and other bidders) would allow to be placed on the target.
- Debt in a capital structure increases enterprise value.
- The seller ...