Required Rate of Return and WACC

Required Rate of Return can also be referred to as the opportunity cost of capital. This represents the rate which should adequately compensate investors for their investments in a company.

The cost of capital is important for several reasons, because: Investors expect a return on their investment sufficient to compensate them for their risk; Value creation is evidenced by a residual positive net present value (NPV) after discounting cash flows at the cost of capital; and many management compensation packages are based on metrics using cost of capital numbers.

The cost of capital can also be described as the rate of return that a firm has to offer finance providers to induce them to buy and hold a financial security. This rate is determined by the returns offered on alternative securities with the same risk.

Investing in government bonds is, usually, considered the safest form of investment available. Government bonds are, normally, associated with the “risk-free” rate of return, and given the symbol rf.

The cost of debt capital: kd = rf + RP

If a company is financed by both debt and equity, then the required return on projects, etc. (of the same risk as the existing set of projects in the firm) is a weighted average of the required returns on each form of finance. In the absence of corporation tax, this gives:

WACC = kd x (proportion of debt) + kE x (proportion of equity), where the proportions of equity and debt are evaluated at market value.

Modigliani and Miller presented a case that in a perfect capital market the increase in kE due to the additional financial risk as gearing rises is only just sufficient to offset the benefit from the increase in the debt proportion. Thus the WACC is constant as the debt weight alters.

By being able to lower the tax burden through financing through debt the effective cost of debt is reduced (the „tax shield effect‟). However, in practice, companies do not use excessive amounts of gearing. One of the reasons firms generally do not select very high financial gearing levels to take advantage of the tax shield benefits is that firms with high borrowing are vulnerable to financial distress.

Bringing it together, when firms are calculating their WACC they should use the target gearing ratio and not a gearing ratio they happen to have at the time of calculation. Calculating the WACC when there are three or more sources of finance: WACC = kd1 x (1-Tc) x (proportion of debt type 1) + kd2 x (1-Tc) x (proportion of debt type 2) + kE x (proportion of equity).

The proportions should: always be based on the market values of debt and equity, not their book values; and reflect the target proportions of debt and equity financing (market values), i.e. based on optimum capital structure estimates; and, finally, always add to one.