How Is WACC Used in Financial Planning to Optimize Capital Structure?

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WACC stands for the weighted-average cost of capital. This is the minimum return required by investors in a company or project. The cost of capital is how much a corporation has to pay out to secure financing. The financing can take the form of debt or equity investments. WACC considers the relative contributions of after-tax debt financing and equity financing to the overall cost of capital. The weighted average is based on the amounts of debt and equity investments.

Opportunity Cost

The cost of capital for a company or project is based on expectations of investors. The cost is equal to the return they would expect on their investments if they invested elsewhere. It is thus an opportunity cost: the cost of forgoing one investment in favor of another. Investors minimize their opportunity costs by selecting companies and/or projects with the highest risk-adjusted returns. For example, if a company has a 10 percent cost of capital, it must pay out a greater-than-10-percent return to attract investors.

Components

The debt component of WACC is simply the average yield a company is paying for its debt. The figure is adjusted to account for the tax deductibility of interest. The cost of equity financing is more difficult to determine, because it must include a risk premium large enough to attract investors. This makes the equity component more costly than the debt component. However, equity financing doesn't require a cash outflow the way debt does, so many companies find the equity component an attractive way to conserve cash.

Calculation

WACC is calculated in these steps: 1. Calculate the company's total financing (TF) and identify its corporate tax rate (TAX). 2. The debt component is the amount of debt divided by the product of the TF, the cost of debt, and the value (1 – TAX). 3. The equity component is the amount of equity funding divided by the product of TF and the cost of equity 4. WACC is the sum of the debt and equity components. For example, given \$300 million in debt costing 8 percent, \$400 million of equity at 18 percent, and a corporate tax rate of 35 percent, WACC equals 12.5 percent.

Optimization

A firm's value is equal to its cash flows' discounted net present value. The discount factor used in this calculation is WACC, so minimizing WACC maximizes a firm's value. However, this may not be an optimal figure if it creates an inordinate debt burden and interest payment cash outflow. The optimal WACC is achieved by deciding how large the debt and equity components should be to offset cash outflows against the firm's value. There are special programs that use advanced numerical techniques to solve this problem, and the curious reader is encouraged to explore the references.

References

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