Weighted cost of capital

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

[edit] 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:

1. Assume no individual or corporate taxes
2. Assume that individuals are able to borrow at the same rate as the firm, (known as home-made gearing)
3. Assume that the market is frictionless, that is no there are no transaction costs
4. 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

[edit] 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.