A Note on the Weighted Average Cost of Capital WACC

Abstract:     
Most finance textbooks (See Benninga and Sarig, 1997, Brealey, Myers and Marcus, 1996, Copeland, Koller and Murrin, 1994, Damodaran, 1996, Gallagher and Andrew, 2000, Van Horne, 1998, Weston and Copeland, 1992) present the Weighted Average Cost of Capital WACC calculation as:

WACC = d(1-T)D% eE% (1)

Where d is the cost of debt before taxes, T is the tax rate, D% is the percentage of debt on total value, e is the cost of equity and E% is the percentage of equity on total value. All of them precise (but not with enough emphasis) that the values to calculate D% y E% are market values. Although they devote special space and thought to calculate d and e, little effort is made to the correct calculation of market values. This means that there are several points that are not sufficiently dealt with: Market values, location in time, occurrence of tax payments, WACC changes in time and the circularity in calculating WACC. The purpose of this note is to clear up these ideas and emphasize in some ideas that usually are looked over.

Also, some suggestions are presented on how to calculate, or estimate, the equity cost of capital.

Published as "Market Value Calculation and the Solution of Circularity between Value and the Weighted Average Cost of Capital". We added a version of appendix of Appendix A to correct and clarify some typos in the appendix published in the paper.

Note: Downloadable document is in English. Spanish version available at http://ssrn.com/abstract=279460

Number of Pages in PDF File: 37

Keywords: Weighted Average Cost of Capital, WACC, firm valuation, capital budgeting, equity cost of capital

JEL Classification: D61, G31, H43, M40, M46

Accepted Paper Series