What estimates are involved in the Weighted Average Cost of Capital formula? Do you feel these estimates are reliable or do they invalidate the use of this measure?
Answer:
(WACC) Weighted average cost of capital is average of minimum after-tax required rate of the return which any company must earn for all its security holders
Formula for (WACC) Weighted average cost of capital
WACC = r(E) × w(E) + r(D) × (1 – t) × w(D)
E
=
Market value of equity
D
=
Market value of debt
P
=
Market value of preferred stock
The following are estimates used at the time to calculating WACC:
- WACC should comprise athe weighted-average of marginal costs for all the sources of capital (equity ,debt, , etc.) .
- (WACC) Weighted average cost of capital should computed after the corporate taxes, since the UFCFs is computed after-tax.
- (WACC)Weighted average cost of capital should use nominal rates of the return to built up from the real rates & expected inflation, because expected UFCFs are generally expressed in the nominal terms.
- WACC should adjusted for systematic risk face by each provider of the capital, because each expects return that is compensates for risk assumed.
- Long-term WACCsmust incorporate the assumptions regarding to the long-term debt rates and not just the current debt rates.
All these estimates are reliable and use to calculate the (WACC) Weighted average cost of capital
