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Weighted Average Cost of Capital

Weighted Average Cost of Capital

Weighted Average Cost of Capital (WACC) is input in the income approach that considers the risk of both types of financing to estimate the Market Value of Invested Capital (MVIC). Companies are generally financed by a combination of debt and equity. The MVIC is calculated by dividing the cash flow available to investors divided by WACC.

WACC may be selected as a discount rate and is based on a blend of the after-tax cost of debt and the cost of equity. The cost of debt is the borrowing rate of the company and it may be a blend of various rates because costs of capital differ depending on the riskiness of the interest-bearing liability. For instance, loans secured by real estate would have a different interest rate than unsecured loans. The cost of equity represents the required rate of return to equity holders. In the event of default, the likelihood of recovery is lower for equity owners than for debt holders. For this reason, the cost of equity is higher than the cost of debt.

In valuing private companies, there can be controversy regarding the application of WACC. The controversy stems from the fact that it is largely based on professional judgment – the MVIC of a company can vary based on different parties’ opinions of what market participants would consider as the appropriate capitalization structure. Since debt is cheaper than equity (due to the deductibility of interest payments and greater perception of safety), a company can take on more debt, thereby decreasing it’s WACC. A lower assumed WACC results in a higher concluded value. Arbitrarily adjusting the leverage can result in significant variance in values.

WACC is most optimally used for large private companies because they are able to borrow independently without the personal guarantees of the owner. The specialist should be cautious using WACC for private companies that cannot take on its own debt without the personal guarantees of the owner. The valuation specialist should read the footnotes to reviewed or audited financial statements for indications of financing arrangements. When deciding whether to apply WACC, the specialist should ask whether the owner is a majority owner with sufficient control to borrow additional funds without personal guarantees. The specialist should also determine the purpose of the valuation and whether the debt and equity borrowing rates used by the specialist reflect the risk of the actual capitalization structure of the company.

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The information contained herein is not necessarily all-inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriately qualified professionals for your plan’s individual facts and circumstances.

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