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Irjfe 26 12
Irjfe 26 12
Fernando Llano-Ferro
Universidad de Bogotá - Jorge Tadeo Lozano Economics Department
Carrera 4 No.22-61 Bogotá- Colombia
Abstract
The Weighted Average Cost of Capital (WACC) is used in finance for several
applications, including Capital Budgeting analysis, EVA® calculations, and firm valuation.
WACC obtained by the standard formula leads to significant errors in Net Present Value of
the Firm calculations; particularly in those that apply perpetual cash flow series. The
present paper identifies the problem, and provides alternative, and accurate formulas to
obtain WACC for Firm Valuation calculations.
I. Introduction
The standard formula to obtain the Weighted Average Cost of Capital (WACC) is included in most
undergraduate, and graduate Corporate Finance textbooks, and it is known by heart by teachers,
students and practitioners around the world.
Ei + D(1 − T )iD
WACC1 = E (1)
(E + D )
Where: E = Annual Free Cash Flow to Equity
iE = Annual cost of equity
D = Annual interest payments (before taxes)
ID = Annual cost of debt
T = tax rate
Subscripts for WACC are used in this paper to identify different methods to calculate it.
This formula is used in EVA®, Capital Budgeting Analysis, Firm valuation, etc.
II. Motivation
The value of a firm can be estimated by adding the Net Present Values of the Free Cash Flows to
Equity, and the Free Cash Flows to Debt; each discounted with the appropriate interest rate.
j =n
FCFE j FCFD j
NPVFIRM = NPVEQUITY + NPVDEBT = ∑ +∑ (2)
j =1 (1 + iE ) (1 + iD ) j
j
An alternative procedure would be to calculate the Net Present Value of the Free Cash Flows to
the firm; discounted with the WACC obtained through equation (1).
International Research Journal of Finance and Economics - Issue 26 (2009) 149
j =n
FCFFj
NPVFIRM = ∑ (3)
(1 + WACC ) j
j =1
For our example WACC2 = 0.1041 would give the exact result. It would also give the correct
result for calculations of Net Present Value of equal and perpetual cash flows.
For the situation where annual Free Cash Flows to the Firm vary, from period to period, a third
formula is required. To simplify somewhat the mathematics, I am going to use the continuously
compounded equivalent interest rate.
Thus:
(1 + i )n = ε i n
*
or:
i* = ln(1 + i ) (6)
150 International Research Journal of Finance and Economics - Issue 26 (2009)
Then the WACC, that would provide accurate results under all circumstances, can be derived
from:
FCFE j
+
FCFD j (1 − T )
=
[FCFE j + FCFD j (1 − T ) ]
ε ji E
ε ji D
ε jWACC 3
obtaining:
1 ⎡ ε ni E ε ni D (FCFE + FCFD (1 − T ) ) ⎤
WACC3 = ln ⎢
(
n ⎣ ε ni D FCFE + ε ni E FCFD (1 − T ) ⎦
⎥
) (7)
In this case, FCFEj is the Free Cash Flow to Equity in period j, and FCFDj is the Free Cash
Flow to Debt, before taxes, in period j.
Please note that WACC3 is not constant. It varies from period to period. It decreases
exponentially as a function of time.
V. Conclusion
We have three possible formulae to calculate WACC´s. The objective is to have a WACC that provides
the same results with Value of the Firm calculations obtained through:
j =n
FCFE j FCFD j
NPVFIRM = NPVEQUITY + NPVDEBT = ∑ + ∑
j =1 (1 + iE ) (1 + iD ) j
j
or:
j =n
FCFFj
NPVFIRM = ∑
j =1 (1 + WACC )
j
WACC1, obtained from the traditional equation (1), which provides approximate results for Net
Present Value of the Firm calculations of a few periods, say 6.
We can use WACC2 (5) which gives accurate results for Net Present Value of the Firm
calculations when applied to constant perpetual cash flows, and approximate results of calculations
with nearly constant perpetual cash flows.
Finally, we can use WACC3 (7), which provides precise results of Net Present Value of the
Firm under all circumstances.
WACC3 varies in every period, decreasing exponentially as a function of time.
References
[1] R.A. Brealey, S.C. Myers, F. Allen PRINCIPLES OF CORPORATE FINANCE. Eight Edition
- McGraw-Hill Companies, Inc. 2006.
[2] McKinsey & Co. VALUATION. University Edition. Fourth Edition. John Wiley & Sons Inc.
2005
[3] A. Damodaran (2005), “Acquisition Valuation”, Leonard N. Stern School of Business, New
York University