The concept of the Weighted Average Cost of Capital (WACC), widely
discussed in textbooks and courses on Financial Management, is often
misunderstood. This note intends to clarify the misconceptions in the
interpretation of the WACC, to ascertain the limited opportunities in
which it can be really applicable, and to provide a summary of the
different courses of action suggested in the literature to estimate the
cost of capital in most business applications when the WACC is not the
best discount rate to use.
Keywords: Financial Management; Cost of Capital; Capital Budgeting;
The concept of the Weighted Average Cost of Capital (WACC), and its
applications, are widely discussed in textbooks on Financial Management
and in business schools around the world. At first glance, the
widespread attention paid to the WACC in academia would appear to be
warranted in light of its ample usage in industry. For instance, in a
survey of leading practitioners, including the most senior financial
officer of 27 large corporations, the most active financial advisers in
mergers and acquisitions, and the best-seller graduate-level textbooks,
Bruner et al. (1998) found that the "WACC is the dominant discount
rate used in DCF analyses". Similarly, in a survey of the largest
100 firms in the Fortune 500 Industrial Firms listing conducted in 1992,
Bierman (1993) reported that 68 of the 74 firms (93%) that responded to
the survey used the WACC.
This popularity of the WACC, particularly its formula, has led some
to surmise a relation between the WACC and the capital structure of the
firm that is not necessarily warranted. Furthermore, evidence of its
prevalent use may be indicative that the financial officers of a
significant number of corporations may be utilizing the WACC for
purposes beyond its true applicability.
The consequences of an improper use of the WACC, particularly as it
pertains to the evaluation of capital investments, may be significant,
not only for individual corporations, but for the economy as a whole.
Since 1998, the annual gross private domestic nonresidential fixed
investments in the United States have exceeded $1,000 billions (U.S.
Department of Commerce, 2007). Even a small deviation from the proper
discount rate used by individual firms to evaluate their investments,
could cause a significant variation in this number in future years.
This note is prepared in an attempt to clarify the misconceptions
in the interpretation of the WACC, to ascertain the limited
opportunities in which it can be really applicable, and to provide a
summary of the different courses of action suggested in the literature
to estimate the cost of capital in most business applications when the
WACC is not the best discount rate to use.
The rest of the article proceeds as follows. Section 2 summarizes
the main purposes for which companies need a discount rate. Section 3
presents the formula for the WACC and explains the most common
misconception that evolves from it. Section 4 discusses the correct
logic behind the WACC. Section 5 lists the limited number of
circumstances when the WACC is applicable and Section 6 briefly
discusses what to do otherwise. Finally, Section 7 contains some
2. WHY A DISCOUNT RATE?
Corporations need a cost of capital (also referred to as the
required, or hurdle, rate) for, at least, three different purposes: (1)
Estimate the value of the firm by calculating the present value of the
estimated future cash flows expected from operations; (2) Analyze new
investment opportunities by estimating their net present value (NPV);
and (3) Evaluate and compensate employees, for example, under the
Economic Value Added (EVA[R]) system discussed by Stern, Stewart and
In general, the WACC is not the discount rate that should be used
for these purposes. The extensive attention paid to it in textbooks and
business schools, however, very often mislead people to use the WACC for
these and other applications where its usage is not appropriate. For
instance, Graham and Harvey (2001) reported that 58.8% of the firms
surveyed would use a single company-wide discount rate to evaluate
projects in an overseas market even under the assumption that they have
different risk characteristics. At the same time, however, in an
apparent contradictory finding like often times occur in survey studies,
51% of the firms also said they would use a risk-matched discount rate
to evaluate projects with different risks. Bierman (1993) indicated that
93% of the companies responding to a survey used their WACC, although
72% also reported using a rate based on the risk or nature of the
project. Brounen, de Jong and Koedijk (2004) found that 58.8% of the
European firms in their sample use the same discount rate for the entire
company when evaluating projects in overseas markets.
3. THE FORMULA AND ITS COMMON MISCONCEPTION
To calculate the WACC, the following familiar formula is used:
[r.sub.A] = [r.sub.d] (1 - t) D/V + [[GAMMA].sub.e] E/V
[r.sub.A] = weighted average cost of capital
[r.sub.d] = cost of debt
t = marginal tax rate
[r.sub.e] = cost of equity
D = amount of debt in capital structure
E = amount of equity in capital structure
V = total value of assets
V = D + E
and V, D, and E should be based on market values.
As is evident from the above formula, the WACC is calculated as an
average of the different financing costs of the firm weighted by the
proportions of debt and equity in the capital structure. At first
glance, this calculation seems to imply that the cost of capital depends
on how the firm is financed. This interpretation, however, is not
correct. Not only that, but it also is inconsistent with the theory of
finance which, ever since Proposition I by Modigliani and Miller (1958),
for the most part has concluded that the value of a firm, and its cost
of capital, is independent of its capital structure.
Modigliani and Miller (1963), in their famous
"correction" paper, revised their earlier conclusions
regarding the tax benefit of debt. This benefit, however, is recognized
by incorporating the term (1 - t) in the WACC formula. Furthermore,
others have expanded the set of factors that help determine the capital
structure of the firm by considering aspects such as personal taxes,
financial distress, agency costs, and information asymmetry. The most
important studies in this literature are summarized by Myers (2001). At
this point, however, no widely accepted alternative has been offered to
the hypothesis that the value of the firm is independent from its
The challenge, therefore, is to reconcile the calculation of the
WACC as a weighted average of the cost of the financing sources of the
firm, with the fact, consistent with the theory of finance, that the
WACC is not, in reality, a function of the capital structure of the
firm. In other words, what then is the correct interpretation of the
4. THE CORRECT LOGIC
The WACC represents an attempt to estimate the rate of return
required to invest in the assets of the firm. This concept is
highlighted by the fact that the symbol that represents the WACC in its
formula is rA, with the subscript A denoting that it is a required rate
calculated for the assets, and not for the sources of financing, of the
Since the objective behind the WACC is to calculate a required rate
of return for the assets of the firm, it would seem logical that the
market-related information of the assets, including their required rates
of return, be analyzed instead of the corresponding information of the
financing sources. In practice, however, the information regarding the
market values of the assets of a firm, and their required rates of
return, are not readily available. Thus, the WACC, particularly the
formula used to calculate it, represents a practical solution to this
problem of not being able to find market-related information regarding
the assets of the firm. To that end, it uses the following two facts:
(1) The two sides of the balance sheet should add to the same total; and
(2) The market-related information is very often easier to find for the
financing sources of the firm than for the assets. Viewed in this light,
the WACC looks at the right-hand side of the balance sheet as a
practical way to assess the left-hand side.
One way in which to visualize this conundrum is to consider a
balance sheet of the firm prepared, not according to historical cost, as
required by Generally Accepted Accounting Principles (GAAP), but based
on market values.
If one were to prepare such a balance sheet, the market values of
assets like accounts receivable, inventories, plant, machinery,
equipment, and many other assets would be needed. These market values,
however, are not often available. By contrast, the market values of the
bonds and common stock of a publicly owned firm are easy to obtain.
Since the total market value of the debt and equity (D & E) must add
to the total market value of the assets (V), to maintain the accounting
identity, using the former is a practical way to analyze the market
values of the latter. The same can be said about the individual required
rates of return, since these also are easier to find for the financing
sources of the firm than for the assets. This approach is the logic
behind the WACC formula and explains why, even though the intention is
to calculate a weighted average of the required rates of return of the
different assets of the firm, we calculate instead the weighted average
of its financing costs.
5. WHEN IS IT CORRECT TO USE THE WACC?
Given that the WACC is calculated as a weighted average of the
costs of the financing sources of the firm only because the
corresponding data on the assets of the firm are not available, the WACC
is only applicable when the systematic risk, including its financial
component, of the assets of the firm is unaltered and when the relation
between both sides of the balance sheet is not materially different.
Only under these circumstances is it reasonable to use the right-hand
side of the balance sheet in lieu of the left-hand side. Otherwise, the
use of the WACC as the appropriate discount rate would be unwarranted.
As a result, the use of the WACC is only limited to the following
two circumstances: (1) To estimate the value of the entire firm, without
changing the asset, or financing, mix; or (2) To evaluate a possible new
investment that is similar in risk and composition to the existing
assets of the firm (e.g., an expansion of the firm's current
business). Otherwise, a different method to obtain the cost of capital
should be used.
In a nutshell, regardless of the inordinate amount of attention
given to it in textbooks and courses on Financial Management, in
practice, the circumstances under which it would make sense to use the
WACC are rather limited in scope and number.
6. WHAT TO DO WHEN THE WACC DOES NOT APPLY
Other than the limited situations described in the previous
section, the WACC would not be the correct cost of capital, or discount
rate, to use. For instance, in a multi-division firm, where each
division operates in a different industry, it is very likely that
projects evaluated in each division are very different to one another in
terms of their systematic risk. The same can be said about the use of
EVA[R] in such a setting, in which case the capital charge applied may
need to recognize these systematic risk differences. In those cases, a
different cost of capital, based on the systematic risk of each division
or activity, has been recommended. In practice, however, the
implementation of this recommendation is hampered by the fact that, by
its very nature, to estimate systematic risk one would need market
information, which is not available for the internal segments of
To address the need to calculate multiple costs of capital within
the firm, some authors have advocated a "pure-play" method, in
which the beta of a division, unavailable for lack of market
information, is estimated based on the information of publicly traded
firms with similar operations. This "pure-play" technique has
been analyzed by Fuller and Kerr (1981), Myer and Nyerges (1994), among
others. Ehrhardt and Bhagwat (1991) and Kaplan and Peterson (1998)
refined this process of estimating beta based on the public information
of similar firms by allowing the use of information from conglomerates,
which typically where excluded from use in the "pure-play"
method because their betas encompass multiple industries. Chua, Chang,
and Wu (2006), however, found that the "pure-play" method
without this refinement works best, and argued that adjusting for
capital structure improves the beta estimates.
Furthermore, Hamada (1972) demonstrated that the systematic risk of
common stocks, even within the context of Modigliani and Miller (1958,
1963), has a financial leverage component. Based on this result, several
authors, including Conine and Tamarkin (1985), recommend adjusting the
cost of capital estimated using the "pure-play" procedure for
any differences between the leverage of the comparable publicly-traded
firms and the division under consideration.
Another procedure that has been offered to address the need to
estimate divisional costs of capital based on the systematic risk of
each segment of a firm is to estimate betas using accounting, instead of
market, information. This accounting approach has been considered by
several authors including Gordon and Halpern (1974), and Hill and Stone
These suggestions regarding the estimation of the cost of capital
are based on the fact that firms should not use one unique cost of
capital in their operations. Instead, firms should use multiple costs of
capital, with each rate reflecting the systematic risk of the projects
or divisions being analyzed.
More than a financing cost, the cost of capital should be
interpreted as a required, or minimum, rate of return that assets should
be expected to offer before the firm should be willing to invest in
them. As such, the cost of capital of an asset depends on its systematic
risk, and not on how it is financed.
Since firms usually conduct operations in different lines of
business, using one uniform cost of capital like, for example, the WACC,
for all assets within a firm is usually wrong. Instead, the cost of
capital should vary by projects or divisions. Therefore, regardless of
the inordinate attention it receives in textbooks and courses on
Financial Management, the WACC is rarely the correct cost of capital
rate to use in practical business applications
REFERENCES AND BIBLIOGRAPHY:
Bierman, Harold, Jr., "Capital Budgeting in 1992: A
Survey," Financial Management (Letters) Vol. XXII(3), 1993, 24.
Brounen, Dirk, Abe de Jong and Kees Koedijk, "Corporate
Finance in Europe: Confronting Theory with Practice," Financial
Management Vol. XXXIII(4), 2004, 71-101.
Bruner, Robert F., Kenneth M. Eades, Robert S. Harris and Robert C.
Higgins, "Best Practices in Estimating the Cost of Capital: Survey
and Synthesis," Financial Practice and Education Vol. VIII(1),
Chua, Jess, Phillip C. Chang and Zhenyu Wu, "The
Full-Information Approach for Estimating Divisional Betas:
Implementation Issues and Tests," Journal of Applied Finance Vol.
XVI(1), 2006, 53-61.
Conine, Thomas E. Jr. and Maurry Tamarkin, "Divisional Cost of
Capital Estimation: Adjusting for Leverage," Financial Management
Vol. XIV(1), 1985, 54-58.
Ehrhardt, Michael C. and Yatin N. Bhagwat, "A Full-Information
Approach for Estimating Divisional Betas," Financial Management
Vol. XX(2), 1991, 60-69.
Fuller, Russell J. and Halbert S. Kerr, "Estimating the
Divisional Cost of Capital: An Analysis of the Pure-Play
Technique," Journal of Finance Vol. XXXVI(5), 1981, 997-1009.
Gordon, Myron J. and Paul J. Halpern, "Cost of Capital for a
Division of a Firm," Journal of Finance Vol. XXIX(4), 1974,
Graham, John R. and Campbell R. Harvey, "The Theory and
Practice of Corporate Finance: Evidence from the Field," Journal of
Financial Economics Vol. LX(2/3), 2001, 187-243.
Hamada, Robert S., "The Effect of the Firm's Capital
Structure on the Systematic Risk of Common Stocks," Journal of
Finance Vol. XXVII(2), 1972, 435-452.
Hill, Ned C. and Bernell K. Stone, "Accounting Betas,
Systematic Operating Risk, and Financial Leverage: A Risk-Composition
Approach to the Determinants of Systematic Risk," Journal of
Financial and Quantitative Analysis Vol. XV(3), 1980, 595-637.
Kaplan, Paul D. and James D. Peterson, "Full-Information
Industry Betas," Financial Management Vol. XXVII(2), 1998, 85-93.
Modigliani, Franco and Merton H. Miller, "The Cost of Capital,
Corporation Finance and the Theory of Investment," American
Economic Review Vol. XLVIII(3), 1958, 261-297.
--, "Corporate Income Taxes and the Cost of Capital: A
Correction," American Economic Review Vol. LIII(3), 1963, 433-443.
Myer, F. C. Neil and Richard T. Nyerges, "Pure-Play Proxies
Reexamined," American Business Review Vol. XII(2), 1994, 47-53.
Myers, Stewart C., "Capital Structure," Journal of
Economic Perspectives Vol. XV(2), 2001, 81-102.
Stern, Joel M., G. Bennett Stewart III and Donald H. Chew, Jr.,
"EVA[R]: An Integrated Financial Management System," European
Financial Management Vol. II(2), 1996, 223-245.
U.S. Department of Commerce, Bureau of Economic Analysis, Table
1.1.5 (Gross Domestic Product), August 2007, www.bea.gov.
Dr. Carlos A. Colon-De-Armas earned his Ph.D. at the Krannert
Graduate School of Management, Purdue University in 1984. Currently he
is a professor of finance at the Graduate School of Business of the
University of Puerto Rico, San Juan, and an Adjunct Professor of Finance
at the University of Phoenix, Puerto Rico Campus.
MARKET VALUE BALANCE SHEET
ASSETS DEBT & EQUITY
Current assets $ xx Debt $ xx
Fixed assets xx Common equity xx
Other assets xx
V $XX D&E $XX