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Weighted Average Cost of Capital

In order to compute the cost of capital for a business enterprise, it is necessary to compute the blended
cost of the company’s capital structure. Use of the weighted average cost of capital, or WACC, method
is appropriate when the entire enterprise or invested capital of the business is being valued. The
weighted average takes into account both the cost of debt and cost of equity, each weighted by the mar-
ket value of that individual capital component.

The WACC calculated for a distressed company can often be understated. For instance, a company’s af-
ter-tax cost of debt is lower than its cost of equity. When a company is over-levered, the debt component
receives a higher weight in the WACC calculation. Analysts often overlook the fact that the costs of
both equity and debt increase with greater levels of debt. As leverage increases, the equity in a business
becomes more risky and requires a greater expected return than at lower levels of leverage, all else being
equal.

As a company becomes very highly leveraged, its debt begins to require the higher cost of capital asso-
ciated with equity. If the costs of equity and debt are not appropriately adjusted to account for the in-
creased risk, the lower cost of debt will drive down the WACC. In the extreme case where debt accounts
for 100% of the capital structure, the WACC will equal the after-tax cost of debt unless the appropriate
risk premiums are factored in. Clearly, this would not be the correct WACC. This is one reason why it is
important to select the appropriate capital structure for the WACC when valuing distressed companies.

Determining the appropriate capital structure weighting to use in the WACC can be complex for compa-
nies in financial distress. The current capital structure of a company in financial distress is typically not
"optimal." fn 7 It is also likely that the capital structure of a company in financial distress will change in
the near future, possibly dramatically. When calculating the WACC, the analyst must therefore keep in
mind that the capital structure of the subject company will likely change over the forecast horizon. In
distressed situations, businesses also typically face difficulty raising debt and equity capital. The analyst
should also consider the capital constraints facing the company when estimating the appropriate capital
structure to be used in the WACC.

The choice of capital structure weighting is often indicated by the purpose of the valuation. For example,
if the purpose of the valuation is to estimate the fair market value of the business enterprise, then an op-
timal capital structure is generally assumed. If the purpose of the valuation is to determine the reor-
ganized value of the business as part of a Chapter 11 restructuring, the capital structure called for in the
plan of reorganization is typically used. If the purpose of the valuation is to determine the value of a mi-
nority interest, then the actual capital structure of the firm is sometimes used. There are considerations to
take into account when using each of these indicated capital structures, which are discussed later.

If the purpose of the valuation is to estimate the fair market value of the business enterprise, then an op-
timal capital structure is generally assumed even if the subject company is in financial distress. The ra-
tionale for this is the fact that a buyer of the business enterprise can control the business and can choose
the amount of leverage that optimizes the value of the business. The ability of a buyer to finance the op-

fn 7 Some finance academics contend that achieving an optimal capital structure is an elusive quest and that practitioners should not
obsess over identifying or quantifying an optimal capital structure. That being said, some capital structures are more reasonable and
sustainable for particular industries than others.

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