Weighted Average Cost of Capital (WACC)

Meaning Of WACC

Weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all of its security holders in order to finance the assets that the company is financing. The weighted average cost of capital (WACC) is referred to as the firm's cost of capital. It is important to note that it is dictated by the external market rather than by management. Essentially, the WACC is the minimum rate of return that a company must earn on its existing asset base in order to satisfy its creditors, owners, and other sources of capital, or else they will look elsewhere for investment.

Companies can raise funds from a variety of sources, including common stock, preferred stock and related rights, straight debt, convertible debt, exchangeable debt, employee stock options, pension liabilities, executive stock options, governmental subsidies, and so on. Common stock, preferred stock and related rights are the most common types of debt raised by corporations. It is expected that different securities, which represent different sources of finance, will generate varying returns. The weighted average cost of capital (WACC) is calculated by taking into account the relative weights assigned to each component of the capital structure. The more complicated a company's capital structure is, the more time-consuming it is to calculate the WACC.

WACC can be used by businesses to determine whether or not the investment projects that are available to them are worthwhile.

WACC Formula

WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))

E = market value of the firm’s equity

D = market value of the firm’s debt

V = total value of capital (equity plus debt)

E/V = percentage of capital that is equity

D/V = percentage of capital that is debt

Re = cost of equity (required rate of return)

Rd = cost of debt (yield to maturity on existing debt)

T = tax rate

An extended version of the WACC formula is shown below, which includes the cost of Preferred Stock.

WACC: Cost of Equity X % of Equity + Cost of Debt X % of Debt X (1 - Tax Rate) + Cost Of Preferred Stock X % of Preferred Stock

The purpose of the WACC is to determine the cost of each component of a company's capital structure based on the proportion of equity, debt, and preferred stock that the company presently has. Each component has a monetary value to the organization. The company's debt is subject to a fixed rate of interest, and its preferred stock has a fixed dividend yield. Despite the fact that a company does not pay a fixed rate of return on common equity, it does frequently distribute dividends to equity holders in the form of cash.

The weighted average cost of capital is an integral component of a DCF valuation model, and as such, it is an important concept for finance professionals to understand, particularly those working in investment banking and corporate development. Throughout this article, we'll go over each component of the WACC calculation in detail.

Breakdown of Cost of Equity and Cost Of Debt

Cost of Equity:

The Capital Asset Pricing Model (CAPM), which equates rates of return to volatility, is used to calculate the cost of equity (risk vs reward). The following is the formula for calculating the cost of equity:

Re = Rf + β × (Rm − Rf)

Where:

Rf = the risk-free rate (typically the 10-year U.S. Treasury bond yield)

β = equity beta (levered)

Rm = annual return of the market

Alternatively, the implied cost of equity is referred to as the opportunity cost of capital. According to theory, it is the rate of return required by shareholders to compensate them for the risk of investing in a particular company's shares (stock). The beta of a stock is a measure of the stock's return volatility in comparison to the overall market.

Cost of Debt:

Making the determination of the cost of debt and preferred stock is probably the most straightforward part of the WACC calculation. The cost of debt is equal to the yield to maturity on the company's debt, and the cost of preferred stock is equal to the yield on the company's preferred stock, in the same way. The cost of debt and the yield on preferred stock can be calculated by multiplying them together with the proportions of debt and preferred stock in a company's capital structure.

The cost of debt must be multiplied by (1 – tax rate), which is known as the value of the tax shield, in order to account for interest payments that are tax-deductible. This is not done in the case of preferred stock because preferred dividends are paid out of after-tax profits rather than before-tax profits.

Take the weighted average current yield to maturity of all outstanding debt and multiply it by one minus the tax rate to get the after-tax cost of debt, which can then be used in the WACC formula to calculate the cost of debt.

Importance of weighted average cost of capital (WACC)

Investment Decisions by the Company:

With the help of WACC calculations, companies can make investment decisions based on the evaluation of their current and future projects.

Project evaluation with similar risk:

When the new projects have a risk level that is similar to or the same as the risk level of the company's existing projects, it becomes an appropriate and preferred benchmark rate for determining whether or not to accept or reject the new projects. Suppose a furniture manufacturer wishes to expand its operations into new markets by building a new factory to manufacture the same type of furniture in a different location. For purposes of generalization, a company entering new projects in its own industry can reasonably assume a similar level of risk and use the WACC as a hurdle rate to determine whether or not to proceed with the project.

Project evaluation with different risk:

When evaluating a project, the WACC is an appropriate metric to use. WACC, on the other hand, is predicated on two assumptions. These assumptions are that all of the projects under consideration have the "same risk" and the "same capital structure," respectively. Is there anything one can do in the event that both of these assumptions are incorrect? WACC can still be used, but with some modifications, depending on the risks involved and the target capital structure desired. Risk-adjusted WACC and adjusted present value, among other concepts, are used to get around the problems associated with WACC assumptions.

Discount Rate in Net Present Value Calculations:

A widely used method of evaluating projects to determine the profitability of an investment is the net present value (NPV) method of calculation. In NPV calculations, the WACC is used as the discount rate or as the hurdle rate. The WACC is used to discount all of the free cash flows and terminal values in the model.

Economic Value Added:

The EVA of a company is calculated by subtracting the cost of capital from the company's profits. When calculating the EVA, the WACC is used to represent the cost of capital for the organization. WACC may also be referred to as a measure of value creation in this context.

Valuation:

The future cash flows of the company will be used to determine the value of the company, and the WACC will be used to discount these future cash flows. The investor will determine the value of a firm or company based on the outcome of the analysis.

Pros and Cons:

Pros

Easy to calculate: The calculation of WACC is straightforward and straightforward. It does not necessitate any specialized knowledge.

One for all: We only need one ratio, and we can use it for any and all new projects or investments. When we compare them to one another in terms of capital costs, it is reasonable to accept or reject the project.

Quick decision making: Using WACC, management can make quick decisions by comparing project profitability to the projected WACC.

Cons:

Lack of public information: It is difficult to calculate the WACC for private companies because the information is not readily available to the public. It is simple for a publicly traded company because they are required to release their financial statements. Furthermore, their financial statements are audited, which makes them more trustworthy. If we look at small and medium-sized businesses, we will find that they will not divulge their confidential information to the public at large. Furthermore, no professional auditors are involved in the review of the reports.

Change in Capital Structure: WACC is based on the assumption that the company's capital structure will remain constant over time. When a new project is accepted, however, the capital structure of the company will change. New projects may be financed through debt or equity, resulting in a change in the capital structure as well as the WACC.