The Weighted Average Cost of Capital 225Most important business decisions require capital. For example, when Daimler-Benz
decided to develop the Mercedes ML 320 sports utility vehicle and to build a plant in
Alabama to produce it, Daimler had to estimate the total investment that would be re-
quired and the cost of the required capital. The expected rate of return exceeded the
cost of the capital, so Daimler went ahead with the project. Microsoft had to make a
similar decision with Windows XP, Pfizer with Viagra, and South-Western when it
decided to publish this textbook.
Mergers and acquisitions often require enormous amounts of capital. For example,
Vodafone Group, a large telecommunications company in the United Kingdom, spent
$60 billion to acquire AirTouch Communications, a U.S. telecommunications com-
pany, in 1999. The resulting company, Vodafone AirTouch, later made a $124 billion
offer for Mannesmann, a German company. In both cases, Vodafone estimated the in-
cremental cash flows that would result from the acquisition, then discounted those
cash flows at the estimated cost of capital. The resulting values were greater than the
targets’ market prices, so Vodafone made the offers.
Recent survey evidence indicates that almost half of all large companies have ele-
ments in their compensation plans that use the concept of Economic Value Added
(EVA). As described in Chapter 9, EVA is the difference between net operating profit
after-taxes and a charge for capital, where the capital charge is calculated by multiply-
ing the amount of capital by the cost of capital. Thus, the cost of capital is an increas-
ingly important component of compensation plans.
The cost of capital is also a key factor in choosing the mixture of debt and equity
used to finance the firm. As these examples illustrate, the cost of capital is a critical
element in business decisions.^1The Weighted Average Cost of Capital
What precisely do the terms “cost of capital” and “weighted average cost of capital”
mean? To begin, note that it is possible to finance a firm entirely with common equity.
However, most firms employ several types of capital, called capital components, with
common and preferred stock, along with debt, being the three most frequently used
types. All capital components have one feature in common: The investors who pro-
vided the funds expect to receive a return on their investment.
If a firm’s only investors were common stockholders, then the cost of capital would
be the required rate of return on equity. However, most firms employ different types
of capital, and, due to differences in risk, these different securities have different re-
quired rates of return. The required rate of return on each capital component is called
its component cost, and the cost of capital used to analyze capital budgeting deci-
sions should be a weighted average of the various components’ costs. We call this
weighted average just that, the weighted average cost of capital, or WACC.
Most firms set target percentages for the different financing sources. For example,
National Computer Corporation (NCC) plans to raise 30 percent of its required capital
as debt, 10 percent as preferred stock, and 60 percent as common equity. This is its tar-
get capital structure. We discuss how targets are established in Chapter 13, but for
now simply accept NCC’s 30/10/60 debt, preferred, and common percentages as given.The textbook’s web site
contains an Excel file that
will guide you through the
chapter’s calculations. The
file for this chapter is Ch 06
Tool Kit.xls, and we encour-
age you to open the file and
follow along as you read the
chapter.(^1) The cost of capital is an important factor in the regulation of electric, gas, and telephone companies. These
utilities are natural monopolies in the sense that one firm can supply service at a lower cost than could two
or more firms. Because it has a monopoly, your electric or telephone company could, if it were unregulated,
exploit you. Therefore, regulators (1) determine the cost of the capital investors have provided the utility
and (2) then set rates designed to permit the company to earn its cost of capital, no more and no less.