UVA-F-0910

THE CORPORATIONS COST OF CAPITAL

AND THE WEIGHTED-AVERAGE COST OF CAPITAL
The cost of capital is the minimum acceptable rate of return for new investments in the
corporation. If management invests in a new venture with an expected rate of return higher than the
cost of capital, firm value increases. Conversely, if the rate of return is less than the firms cost of
capital, firm value will be destroyed, and the companys common stock price will fall.
The cost of capital is not something dictated by management. It must be discovered by
estimating the rate of return demanded by the individual investors who buy the firms bonds and
stocks. These investors are seeking a return on their investments that compensates them for both the
time value and risk. This required return also is available to the firm because the firm can buy its
own stocks and bonds on the market. When managers choose to invest in a project rather than in the
firms own securities, they are forgoing the opportunity to earn the cost of capital in favor of the
return on the new investment. In this sense, the cost of capital is the opportunity cost of investing.
A simple example will illustrate this concept. Assume that the Grand Majestic Auto
Company is considering expanding automobile production to meet increased demand. Grand
Majestic is entirely equity financed, which means that the market value of the firm equals the market
value of the common stock outstanding. The single-lined rectangles in the following diagrams
represent current market values, and the double-lined blocks depict the planned expansion to be
funded by new equity:
Net Working
Capital

New
NWC

Fixed
Assets

New
FA

New
Common

Common

Stock

Stock

This format is similar to that of a standard balance sheet except that current liabilities have
been transferred to the left side and netted against current assets to give net working capital. The
idea is to consider only the permanent or long-term sources of capital such as long-term debt and

This technical note was prepared by Professor Kenneth M. Eades. Copyright 1989 by the University of Virginia
Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a
spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying, recording, or
otherwisewithout the permission of the Darden School Foundation. Rev. 9/03.

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preferred and common stock in the cost-of-capital computation. Net working capital includes
accounts payable and wages payable, but normally it would not include bank loans or current longterm debt because these carry explicit interest costs and are normally considered permanent sources
of funds.
To determine the fair rate of return for investing in an automobile production facility, we
must first assess the risk of the new endeavor. Because Grand Majestic is considering expanding the
current line of business, the basic business risk of the new assets will be the same as that of the
existing assets. The risk/return principle states that investments of equal risks must also have equal
required returns. Thus, Grand Majestics current cost of capital is the appropriate hurdle rate for the
expansion. This insight is important; to use Grand Majestics cost of capital to evaluate an
investment from a different risk class would be incorrect. For example, if Grand Majestic were
considering investing in a stereo-retailing chain, management should use the cost of capital for
stereo retailing rather than auto manufacturing.
Because common stock is Grand Majestics sole source of funds, the cost of capital is simply
the cost of equity (KE), which is the rate of return currently required by the market for investing in
Grand Majestic shares.1 If the cost of equity, for example, is estimated to be 15%, management
should proceed only if the expected return on the expansion exceeds 15%.
Weighted-Average Cost of Capital
Consider a more realistic situation than all-equity financing, such as when a firm is financed
by both debt and equity. In this case, the firms cost of capital is a composite cost of debt and equity,
i.e., a weighted-average cost of capital (WACC). To illustrate, assume that Grand Majestic has 1,000
shares of common stock and 100 bonds outstanding. The Wall Street Journal reports the closing
price of Grand Majestics stock to be $60, and the price of a Grand Majestic bond to be $900. The
firms market values now look like the following:

Net Working
Capital

Fixed Assets

Debt
D = 100 $900
= $90,000
Common Stock
E = 1000 $60
= $60,000

Methods for estimating the cost of equity include the dividend-growth model, the naive risk-premium method, and
the capital asset pricing model (see the note [UVA-F-0911] Introduction to the Cost of Equity for further details).

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The total value of the firm V equals the sum of the market value of debt D plus the market value of
equity E, i.e.,
V=D+E
V = (100 bonds $900/bond) + (1000 shares $60/share)
V = $90,000 + $60,000
V = $150,000
Investments chosen by management must now satisfy both the bondholders, who own D/V =
$90,000/$150,000 = 60% of the firm, and the stockholders, who own E/V = $60,000/$150,000 =
40% of the firm. Of the two groups of investors, the bondholders are easier to satisfy because
interest and principal payments must be paid before the stockholders can receive dividends or any
other cash distributions. Moreover, interest payments to bondholders are deductible from before-tax
income, which lowers the effective cost of debt for Grand Majestic. For example, if the yield to
maturity on Grand Majestic bonds is currently 10%, then the pretax cost of debt KD is also 10%.
However, if Grand Majestics tax rate t is 34%, the after-tax cost of debt is only 6.6% [10% (1
.34)].2 Unfortunately, equity funds provide no tax advantage, so if equity investors require a 20%
return, the cost of equity to the company KE is exactly 20%.
The weighted-average cost of capital formula is

WACC =

D
E
K D (1 t) + K E
V
V

(1)

where V = D + E. Substituting for the symbols gives

90
60
(.10)(1 .34) +
(.20)
150
150
= .6(.10)(.67) + .4(.20)

WACC =

= 11.96%
This example illustrates several important points. First and foremost, WACC is a marketvalue concept. Management needs to know the cost of capital to make better decisions for the firms
ownersin this case, the bondholders and stockholders. Individuals who buy stocks and bonds are
primarily interested in the returns they realize on their investments, and although historical costs and
book values may be relevant for judging current market value, ultimately only the market price
2

The rationale behind using the after-tax cost of debt is that paying $1 of interest reduces taxable income by $1,
which in turn reduces the tax bill by $0.34. Thus, the effective cost of $1 interest is only $0.66, which equals (1 34%)
$1.

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matters. Therefore, we use the market values of debt and equity and the estimated required market
rates of returns for debt and equity to compute WACC.
The second point is that the use of debt financing increases the cost of equity and the cost of
debt because of the risk/return principle. In particular, the cost of equity is 20% when debt is 60% of
the capital structure, whereas it was only 15% when we assumed Grand Majestic was all-equity
financed. The increased cost of equity should not be surprising because the equity becomes more
risky as the firm substitutes debt for equity. Interestingly, even though the added financial risk
drives the cost of equity from 15% to 20%, the result is a decrease in the weighted cost of capital.
The WACC is reduced because debt is a cheaper source of funds than equity, and this cost savings
more than offsets the increased equity cost when the costs are averaged together.
Of course, there is a limit to the amount of debt any company can comfortably support. For
example, suppose Grand Majestic decided to maintain a capital structure with 80% debt. If the
increased financial risk prompted investors to demand that KD = 12% and KE = 30%, the WACC
would become:
D
E
K D (1 t) + K E
V
V
WACC = (.8)(.12)(1 .34) + (.2)(.30)
WACC = 12.34%

WACC =

Thus, at the 80% debt level, WACC is higher than when we assumed debt to be 60% of the
capital structure. The market is telling us that the risk of bankruptcy becomes too high when debt
exceeds 60%. The effect is an increased WACC and a decrease in overall firm value.
Free Cash Flow, WACC, and Firm Value

Increasing the WACC is equivalent to decreasing firm value because firm value is the
present value of future free cash flows discounted by the WACC. A free cash flow (FCF) is the
after-tax cash flow that would be realizable by an all-equity-financed firm. In other words, we do not
subtract out interest payments because we want to find the cash flow available to pay all owners of
the firm.3 To illustrate the effect of changing the WACC, assume that we can approximate Grand
Majestics future earnings as a perpetuity:

Most texts and teaching notes refer to FCF as simply cash flow (e.g., see Cash Flow and the Time Value of
Money, HBS 9-177-012). We use the term free to distinguish this concept from a residual cash flow, from which
interest and debt principal payments have been subtracted.

-5Sales
Cost of goods sold
Gross margin
Sales & administration
Earnings before
interest and taxes (EBIT)
Taxes (34%)
Net operating
profit after tax (NOPAT)

UVA-F-0910
$402,275
370,093
32,182
5,000
27,182
9,242
$ 17,940

FCF equals NOPAT4 plus depreciation less capital expenditures and increases in net working
capital. A common assumption, however, is that a firm with no growth depreciation exactly equals
capital expenditures, implying that the company is replenishing its assets but not growing beyond its
current capacity. Furthermore, without growth in revenues it may be reasonable to assume increases
in net working capital are zero, as the firm will not increase its levels of receivables, payables, or
inventories. If we accept these assumptions, FCF equals net income. Again, notice that the income
statement excludes interest expenses, because we are solving for the dollars available for all the
owners of the firm, not just the equity holders. The tax advantage of debt is intentionally omitted in
the cash-flow computation; it is incorporated in the WACC, and we do not want to double-count it.
If the FCF is a perpetuity, firm value is
V=

FCF
WACC

(2)

Because FCF is constructed to be independent of the amount of debt in the capital structure, only
WACC changes V in Equation 2. Therefore, as WACC decreases, firm value increases, and vice
versa. Notice how V changes for the different WACC values we have computed so far:
FCF = $17,940
WACC (100% equity) = 15.00%V = 17,940/.15 = $119,600
WACC (40% equity) = 11.96%V = 17,940/.1196 = $150,000
WACC (20% equity) = 12.34%V = 17,940/.1234 = $145,380
This pattern suggests that Grand Majestic should finance the expansion with about 60% debt
and 40% equity; this is the mix of capital that maximizes firm value. It is no accident that

Because Grand Majestic has no debt, NOPAT equals net income. For a firm with interest expense, it is necessary to
compute taxes based on EBIT to compute NOPAT.

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discounting FCF at 11.96% gives the same $150,000 firm value we computed earlier merely by
adding the 60% debt and 40% equity values together.
To emphasize how closely linked the computations are, we can start with FCF and go
backwards to solve for the cost of equity. The trick is to remember that the FCF must be distributed
between the bondholders and equityholders and that we already know D = $90,000, E = $60,000,
and KD = 10%:
Interest payments in perpetuity = KD D
= 10% $90,000
= $9,000
Dividends = FCF After-tax interest payments
= $17,940 $9,000(1 .34)
= $12,000
KE = Dividends/Equity value

= $12,000/$60,000
= 20%
Remember that we are assuming just enough reinvestment in the firm to keep FCF constant (i.e.,
depreciation equals new investment). Therefore, Grand Majestic will remain forever at its current
size, as will the common-stock price. If the stock is not expected to appreciate, the dividend is the
only way the stockholder can be compensated for bearing the risk of the investment (i.e., KE =
Dividend per share/Price per share).
Miscellaneous Issues

A few hidden assumptions in our analysis should be kept in mind. As mentioned earlier, the
cost of capital is specific to the risk class being considered. If the company has several divisions in
different lines of business, a different cost of capital should be used for each division. The best way
to determine a divisional cost of capital is to compute the cost of capital for other companies in the
same line of business as the division. These comparable companies would ideally be pure play
firms; that is, their business should be restricted to the same as that of the division.
Although not explicitly stated, we have assumed throughout that the current proportions of
debt and equity are also the target weights. By target weights, we mean the long-run mix of debt and

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equity. If the firm is currently all equity, but management is planning to shift the capital structure to,
say, 60% debt, computing WACC under the assumption of no debt would be inappropriate.
Unfortunately, the solution to the problem is not simply to change the weights in the WACC formula
and use an expected KD and an estimated KE as the costs of capital. The cost of equity estimated
when no debt is in the capital structure will be an underestimate of the new KE when 60% of the
funding is borrowed.
To solve this problem, the analyst can either adjust KE for the added financial risk or use the
KE of another firm that happens to have the same business and financial risks as the company being
analyzed. Finding the perfect match is difficult because it should be in exactly the same line of
business and borrow 60% of its funds. If we choose instead to revise KE upward to reflect the new
financial risk, we need to use another formula (which is beyond the scope of this note).5 For the
moment, however, it is sufficient to recognize the problem and not attempt to solve it naively.
A final issue is the effect of a more complicated capital structure. In particular, how does the
WACC change if the firm has many issues of debt outstanding or if the firm has preferred stock in
addition to debt and common stock? These complications are easily handled by adding terms to the
WACC formula. For example, if a firm is 60% debt financed, half of which is bank borrowing and
half of which is held as public bonds, the cost of debt is simply a weighted average of the two
sources of borrowing. If the firm has preferred stock in addition to debt and common equity, the
WACC formula becomes:
WACC =

D
E
P
K D (1 - t) + K E + K p
V
V
V

where P = Market value of outstanding preferred stock, and V = D + E + P. KP = Cost of preferred

stock = Preferred dividend/Price per preferred share.

See Financial Leverage, the Capital Asset Pricing Model and the Cost of Equity Capital (HBS 9-280-100) for a
treatment of risk/return adjustment for the effects of increased financial leverage.