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A Note on the Weighted Average Cost of Capital WACC

Abstract Most finance textbooks present the Weighted Average Cost of Capital WACC calculation as: WACC = Kd×(1-T)×D% + Ke×E% (1) Where Kd is the cost of debt before taxes, T is the tax rate, D% is the percentage of debt on total value, Ke 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 Kd and Ke, | A Note on the Weighted Average Cost of Capital WACC Ignacio Vélez-Pareja Universidad Tecnológica de Bolivar Cartagena Colombia ivelez@unitecnologica.edu.co nachovelez@gmail.com Joseph Tham Duke University ThamJx@duke.edu First Version February 08 2001 This Version June 23 2009 i Abstract Most finance textbooks present the Weighted Average Cost of Capital WACC calculation as WACC Kdx 1-T xD KexE 1 Where Kd is the cost of debt before taxes T is the tax rate D is the percentage of debt on total value Ke 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 Kd and Ke 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 solve the circularity problem 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. Keywords Weighted Average Cost of Capital WACC firm valuation capital budgeting equity cost of capital. JEL codes D61 G31 H43 ii A Note on the Weighted Average Cost of Capital WACC Ignacio Vélez-Pareja Universidad Tecnológica de Bolivar Cartagena Colombia ivelez@unitecnologica.edu.co nachovelez@gmail.com Joseph Tham Duke University ThamJx@duke.edu Introduction 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 Kdx 1-T xD Ke E 1 1 Where Kd is the cost of debt before taxes T is the tax rate D is the percentage of debt on total .