Weighted cost of capital

Weighted cost of capital

Weighted cost of capital (WACC) is the average weighted of cost of equity capital (ke) and cost of debt (kd).

Overview

According to the "Modigliani-Miller theorem", under certain assumptions a firm's WACC remains constant regardless of changes in its capital structure. These assumptions are outlined below:
# Assume no individual or corporate taxes
# Assume that individuals are able to borrow at the same rate as the firm, (known as home-made gearing)
# Assume that the market is frictionless, that is no there are no transaction costs
# Assume that the company has a fixed investment policy being implemented in the strategy of the company Furthermore, M&M theory hypotheses that the cost of equity capital does change as the company increase its gearing level in the same direction of the gearing level. The reason is that as a company increases its leverage, the shareholders require a higher rate of return because the higher fixed interest costs lead to a higher variance in earnings. However, the overall WACC doesn't change. Employing an arbitrage argument, M&M showed that as a company increases its gearing level the cost of equity changes in such a way to keep the WACC constant.note:decision criterion:

accept if IRR ≥ cost of capital

reject if IRR < cost of capital

Formulas

The formula is derived by: ke (e/v) + kd (d/v), where v = d + e.

But with the existence of taxes in the real world, it does change by the formula: ke (e/v) + kd (1-tc)(d/v), where tc = tax rate of the company.


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