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The Weighted Average Cost of Capital as a Marginal Criterion

Nicos Zafiris

Journal of Finance and Investment Analysis, 2016, vol. 5, issue 4, 1

Abstract: This paper addresses apparent definitional gaps and ambiguities in existing references to the marginal aspects of the weighted average cost of capital (WACC) and reviews its role as a benchmark in investment appraisal. A selection of typical statements, both from the finance and economics traditions, is presented to highlight limitations of the current state of the debate, and to reconcile modelling styles in the area. The commonly advanced justification for the use of WACC as a criterion on grounds of practicality only is criticised as subject to unduly restrictive conditions, especially unchanged gearing. Alternative Marginal Factor Cost (MFC) definitions for equity and debt are proposed, and their properties explored. The corresponding MFC curves cross over at the minimum WACC which can then serve as a marginal criterion under optimal gearing. Minimum WACC is also derived from a profit maximisation model and WACC is thus shown to be compatible with marginalism in so far as profit maximisation applies. A related aim of the analysis presented is to inform pedagogy in the area by crossing the boundary between economics and finance modelling.

Date: 2016
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Handle: RePEc:spt:fininv:v:5:y:2016:i:4:f:5_4_1