WACC and Capital Structure

Weighted Average Cost of Capital (WACC) — the weighted average cost of all sources of capital for a company. WACC is used as the discount rate for evaluating projects and the company as a whole. Understanding WACC and its components is critically important for financial decisions. WACC formula: WACC = (E/V) × Re + (D/V) × Rd × (1-T). Where E = market value of equity, D = market value of debt, V = E + D (total capital), Re = cost of equity, Rd = cost of debt, T = tax rate. Intuition: WACC is a blended cost reflecting the weights of each capital source. Debt is cheaper (lower risk, tax shield), equity is more expensive (residual claim, no tax benefit). Cost of debt (Rd) Observable: yield to maturity on company’s bonds, or the interest rate on bank loans. For rated companies, corporate bond yields of similar rating. Pre-tax vs after-tax: interest expense is tax-deductible, creating a tax shield. After-tax cost of debt = Rd × (1-T). This is the “true” cost after the tax benefit. Example: company’s bonds yield 6%, tax rate 25%. After-tax cost = 6% × (1-0.25) = 4.5%. Tax shield Tax shield = Interest × Tax Rate. This is a reduction in taxes thanks to interest deductibility. Value of tax shield: present value of the expected tax shields adds to firm value. This is the benefit of debt financing. Limitations: tax shield is valuable only if the company has taxable income. Losses eliminate the immediate benefit (though NOLs can carry forward). Weights: book vs market Market value weights: conceptually correct — reflect the actual cost of raising new capital today. WACC should use market values. Book value weights: sometimes used when market values are unavailable or unstable. For debt, book often approximates market (if yields are stable). Target weights: for forward-looking WACC, use the target capital structure (management’s intended mix), not current. WACC calculation example Company: Equity market value $800M, Debt market value $200M, Cost of equity 12%, Cost of debt 6%, Tax rate 25%. WACC = (800/1000) × 12% + (200/1000) × 6% × (1-0.25) = 0.80 × 12% + 0.20 × 4.5% = 9.6% + 0.9% = 10.5%. This 10.5% — discount rate for valuing firm’s cash flows. Optimal capital structure Trade-off theory: optimal structure balances tax benefits of debt against costs of financial distress. Moderate leverage minimizes WACC, maximizes firm value. Tax benefit: more debt → lower WACC (debt is cheaper). But excessive debt → increased probability of distress → higher costs. Financial distress costs: direct (legal, administrative) and indirect (lost sales, supplier reluctance, employee flight). These offset tax benefits at high leverage. Modigliani-Miller theorems MM Proposition I (no taxes): capital structure is irrelevant to firm value. V = V_unlevered. Value depends on operating cash flows, not financing. MM Proposition II (no taxes): cost of equity increases with leverage (Re = Ru + (Ru - Rd) × D/E). Leverage creates risk for equity holders. With taxes: debt creates a tax shield. V_levered = V_unlevered + PV(tax shield). Optimal structure → 100% debt (unrealistic). Practical implication: MM provides a theoretical framework, but real-world factors (distress costs, agency costs, information asymmetry) create an optimal interior solution. Pecking order theory Alternative view: companies prefer internal funds, then debt, then equity (last resort). Driven by information asymmetry — equity issuance signals overvaluation. Implication: no target capital structure. Financing follows needs. High leverage = limited internal funds, not optimization. Evidence: both theories have empirical support. Companies exhibit trade-off and pecking order behavior. Using WACC in valuation DCF: discount FCFF at WACC → Enterprise Value. Subtract debt, add cash → Equity Value. Consistency: FCFF is available to all capital providers, WACC reflects the cost of all capital. Match numerator and denominator. Project evaluation: use WACC as hurdle rate if project risk is similar to company average. Adjust for project-specific risk if it differs. WACC limitations Static assumption: WACC assumes constant capital structure. If the structure changes, WACC changes. Single rate: WACC is a single discount rate for all cash flows. But risk can vary by project, time period. Estimation uncertainty: cost of equity (CAPM inputs) is uncertain. Small changes in assumptions → significant WACC changes. Practical tips Use target (not current) capital structure for forward-looking WACC. Sensitivity analysis: test valuation with different WACC assumptions. Present a range of values. Cross-check: compare WACC to industry peers, historical returns. Outliers warrant investigation.