Weighted Average Cost of Capital

Weighted average cost of capital (abbreviation WACC from English Weighted Average Cost of Capital ) describes firstly an approach to company valuation that works with weighted average capital costs , and secondly a method for determining the minimum return on investment projects.

overview

The economists Merton Miller and Franco Modigliani have shown in their Modigliani-Miller theorems that in a perfect economy without taxes, the company value is independent of the level of debt. However, since many governments allow debt interest rates to be deducted from the tax base, this creates a tendency to leverage.

The point of the discounted cash flow method consists in an exact (quantitative) determination of the tax advantage from a proportionate external financing. So the amount of the tax advantage depends on the company's financing policy. In many cases, only a corporate tax (e.g. corporation tax or trade tax ) is assumed, the taxation of shareholders is neglected.

If we continue to assume that the company operates a so-called (market) value-oriented financing (with market -value-oriented financing, the future debt capital ratio, i.e. the ratio of debt capital to share value, is precisely specified for the entire future, deviations or other uncertainties are excluded ), then the WACC approach (weighted average cost of capital) is appropriate. If one uses deterministic WACC in each period to determine the company value (which is usually assumed for the sake of simplicity), then this corresponds to the requirement of market value-oriented financing - if the company is not financed on the basis of market value, then the correct company value will not match the WACC value.

In addition to the WACC approach, the TCF or FTE approach can also be used. All three procedures lead to the same company value. Which of the three methods you use depends on what information the evaluator has. The WACC procedure assumes that the valuer knows the expected cash flows of the non-indebted company and also the weighted cost of capital of the indebted company. Both the FTE and the TCF make different assumptions about this information.

Calculation of the WACC

Calculation tree for the weighted average cost of capital (WACC)

The value for WACC is determined as the weighted average of the equity and debt capital costs, whereby the debt capital costs are to be reduced by the tax advantage:

${\displaystyle WACC\ =\ \left({E \over V}\right)\cdot k^{E}\ +\ \left({D \over V}\right)\cdot k^{D}(1-s_{C})}$

in which

${\displaystyle \ V=D+E}$

using the following symbols:

symbol	meaning	unit
${\displaystyle \ WACC\ }$	weighted average cost of capital (after corporation tax)	%
${\displaystyle \ k^{E}\ }$	Interest rate claim of the equity capital provider (calculated according to the CAPM as a risk-free capital investment + risk premium)	%
${\displaystyle \ k^{D}}$	Interest required by the lender or borrowing costs	%
${\displaystyle \ s_{C}}$	Corporate tax rate (corporate tax rate)	%
${\displaystyle \ D}$	Market value of borrowed capital	currency
${\displaystyle \ E}$	Market value of equity	currency
${\displaystyle \ V}$	Total company value (E + D)	currency

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

The corporation tax deduction is based on the following assumptions: First, the company's annual net income is distributed continuously as dividends. Second, it assumes that dividends are subject to the same income tax as alternative investment income and that income tax is negligible. Thirdly, the company's equity income is also subject to corporation tax (and trade tax), but debt income is not. Therefore, the required returns are before corporation tax and . By multiplying it by the tax factor, you get the returns after corporation tax shown in the formula . Conversely, the cost of capital before tax is obtained by dividing the above expression for the WACC by the tax factor. ${\displaystyle k^{E}/(1-s_{c})}$ ${\displaystyle k^{D}}$

Determination of the company value (WACC approach)

WACC approach to company valuation

Assuming an infinite life of the company, the market value of the company is obtained, taking into account the market value of the non-operational assets, using the following formula: ${\displaystyle N_{0}}$

${\displaystyle Unternehmenswert=\sum \nolimits _{t=1}^{\infty }{\frac {OFCF_{t}}{(1+WACC_{\mathrm {t} })^{t}}}+N_{0}}$

With

• ${\displaystyle WACC_{t}}$ weighted cost of capital of the indebted company at time t
• ${\displaystyle OFCF_{t}}$ expected cash flow of the performance area of ​​a company at time t

The entity approach based on the WACC is the most widespread variant of the discounted cash flow method . The WACC approach separates the company into a service area for which the operating free cash flow is forecast ( OFCF ) and a Financing area, which includes the measures of external financing by equity and debt capital providers. The free cash flow of the service area disregards the tax advantage of increasing external financing. The valuation-relevant cash flow thus corresponds to a payment surplus that would be available to the company if it were fully self-financed (or through no debt).

The neglect of the tax shield when determining free cash flows is remedied by using the tax-adjusted cost of capital rate WACC for discounting. The actual financing (capital structure) of the company is therefore only reflected in the discount rate. The tax savings from future interest on borrowed capital are taken into account by a corresponding reduction in the discount rate.

The WACC procedure (contrary to popular belief) does not require the constancy of the capital structure . The weighted cost of capital can only be calculated using the Miles-Ezzell adjustment formula. The Modigliani-Miller adjustment formula is not applicable because it assumes constant borrowed capital, which means an autonomous financing policy and means a contradiction to market value-oriented financing. The Modigliani-Miller theorem remains valid.

• Economic Value Added
• Cash value added
• Company valuation
• Discounted cash flow
• Entity method
• APV approach
• TCF approach

Individual evidence

1. ↑ Weighted average cost of capital. In: Academy Herkert. Accessed December 1, 2018 . 
2. ↑ Janette Rutterford and the B821-Course Team (2002) Finance Tools The Open University, Milton Keynes ISBN 0-749-25729-6 ; P. 33 ff.
3. ↑ L. Kruschwitz, A. Löffler: A new approach to the concept of discounted cash flow . In: Journal for Business Administration . tape 55 , 2005, pp. 21-36 .
4. ↑ Frank Richter (1998) company valuation with variable indebtedness, magazine for banking law and banking, 10, 379–389.
5. ↑ L. Kruschwitz, A. Löffler: DCF = APV + (FTE & TCF & WACC)? In: Frank Richter, Andreas Schüler, Bernhard Schwetzler (Hrsg.): Capital provider claims , market value orientation and company value . Franz Vahlen, Munich 2003, ISBN 978-3-8006-3023-3 , pp. 235-254 .
6. ^ Clare Spencer (1998) Vital Statistics The Open University, Milton Keynes ISBN 0-749-23524-1 ; P. 149.
7. ↑ A. Löffler. Two comments on WACC. Zeitschrift für Betriebswirtschaft, 74 (2004), pp. 933-942.
8. ↑ James A. Miles and John R. Ezzell (1980), The weighted average cost of capital, perfect capital markets, and project life: a clarification, Journal of Financial and Quantitative Analysis, 15, 719-730.
9. ^ M. Miller and Franco Modigliani : Corporate income taxes and the cost of capital: a correction. American Economic Review, 48 (1963), pp. 261-297.

Web links and literature

• Scientific literature on the subject of WACC and company valuation
• Video about practical application of the WACC method
• Tom Copeland, Tim Koller, Jack Murrin: Company Value . Methods and strategies for value-oriented corporate management. 3rd completely revised and expanded edition. Campus-Verlag, Frankfurt am Main et al. 2002, ISBN 3-593-36895-1 .