DCF-WEIGHTED AVERAGE COST

 

Weighted Average Cost of Capital: Formula, Examples & How to Calculate

Last Updated : 22 Apr, 2024

What is WACC?

The Weighted Average Cost of Capital (WACC) is a financial metric that represents the average cost of the various sources of financing (equity, debt, preferred stock, etc.) used by a company to fund its operations. It is a crucial concept in corporate finance and capital budgeting decisions because it serves as the discount rate used to evaluate the feasibility of investment projects.

• A company's cost of capital is represented by its weighted average cost of capital (WACC), which is based on the proportionate weighting of each capital type (equity and debt).
• WACC may be computed by taking the market value of each capital source and multiplying its cost by its weight. The total can then be obtained by summing the results.
• WACC is frequently used as a benchmark rate by which businesses and investors assess whether a certain project or purchase is desirable.

What is WACC Used For?

1. Investment Decision Making: WACC serves as the discount rate used to evaluate the feasibility of investment projects. When assessing potential investments or capital expenditure decisions, companies compare the expected returns from the project to the project's cost of capital (WACC). Projects with a positive net present value (NPV) when discounted at the WACC are typically considered acceptable investments.

2. Capital Budgeting: WACC helps companies prioritize investment opportunities by providing a benchmark for evaluating the risk-adjusted returns of different projects. It allows businesses to allocate capital efficiently by focusing on projects that are expected to generate returns above the company's cost of capital.

3. Valuation of Companies: WACC is used in discounted cash flow (DCF) valuation models to determine the present value of a company's future cash flows. By discounting future cash flows at the company's WACC, analysts can estimate the intrinsic value of the company's equity. This valuation method helps investors assess whether a company's stock is undervalued or overvalued relative to its expected future cash flows.

4. Mergers and Acquisitions (M&A): WACC plays a significant role in M&A transactions by helping acquirers determine the appropriate purchase price for a target company. By discounting the target company's future cash flows at the acquirer's WACC, acquirers can assess the financial impact of the acquisition and determine whether it will create value for shareholders.

Formula of WACC

$WACC=(\frac{E}{V}\times r_e)+(\frac{D}{V}\times r_d\times (1-T_c))+(\frac{P}{V}\times r_p)$

• E = Market value of the company's equity
• D = Market value of the company's debt
• P = Market value of the company's preferred stock
• V = Total market value of the company's capital structure (E + D + P)
• re​ = Cost of equity
• rd = Cost of debt
• rp​ = Cost of preferred stock
• Tc = Corporate tax rate

Examples of WACC

Assuming the following information, calculate WACC:

• E = 50,000
• Re = 60,000
• D = 80,000
• V = 130,000
• Rd = 90,000
• Tc = 20%

$WACC=(\frac{E}{V}\times r_e)+(\frac{D}{V}\times r_d\times (1-T_c))+(\frac{P}{V}\times r_p)$

$WACC=(\frac{50,000}{1,30,000}\times 60,000)+(\frac{80,000}{1,30,000}\times 90,000\times (1-0.2))$

WACC = 23,077 + 44,308

WACC = 67,385

How do I calculate WACC?

Determine the Components of Capital: Identify the different sources of capital that a company uses to finance its operations. These typically include equity, debt, and sometimes preferred stock.

1. Calculate the Cost of Equity (Re): The cost of equity represents the return that shareholders expect from investing in the company's stock. It can be calculated using various methods, such as the Capital Asset Pricing Model (CAPM), Dividend Discount Model (DDM), or Gordon Growth Model (GGM).

2. Calculate the Cost of Debt (Rd): The cost of debt is the interest rate the company pays on its debt obligations, such as bonds or loans. It can be either the current interest rate the company is paying on its debt or an estimate based on the company's credit rating and market conditions.

3. Determine the Weight of Each Component: Determine the proportion of each component (equity, debt, preferred stock) in the company's capital structure. This is usually based on the market value or book value of each component.

4. Calculate the Weighted Average Cost of Capital (WACC): Use the following formula to calculate the WACC,

$WACC=(\frac{E}{V}\times r_e)+(\frac{D}{V}\times r_d\times (1-T_c))+(\frac{P}{V}\times r_p)$

Interpretation of WACC

The Weighted Average Cost of Capital (WACC) is a financial metric that represents the average cost a company pays to finance its operations through various sources of capital, such as equity and debt. It's a crucial tool used to evaluate investment opportunities and make strategic decisions.

Interpreting WACC involves understanding it as the minimum rate of return required by investors to compensate for the risk of investing in the company. A higher WACC indicates higher costs of capital and higher risk associated with the company's operations and financing structure. WACC serves as the discount rate used to evaluate the feasibility of investment projects. Projects with returns higher than the WACC are considered acceptable investments, as they create value for shareholders. Conversely, projects with returns lower than the WACC may not meet the company's minimum return requirements and may be rejected.

Variables that Affect WACC

1. Market Rates for Stocks and Debt: The weighted average costs of a company's capital are impacted by both debt and equity. However, the market value of loans and equities takes precedence over the real or book value when examining the WACC. As a result, the weighted average may vary when market prices do since the WACC multiplies the market value by the real cost of each capital source.

2. Rates of Corporation Taxation: The weighted average is also impacted by corporate tax rates since variations in these figures alter the WACC and total net profit. Corporate tax rates often indicate fixed amounts that businesses are required to pay every accounting period. Companies are frequently aware of the consequences of changes in tax rates when they happen.

3. Costs of Debt and Equity: The real expenses that businesses incur for capital debt and stock might affect the WACC, just like market prices do. Even though equity is a representation of the resources that businesses use to make money, equity also needs to be paid out when shareholders get dividends. The equity firms develop might fluctuate in line with their profitability due to the necessity of delivering payments to capital investors. Changes in the price of any capital debt that a business is responsible for can have an impact on the WACC, as can variations in the cost of equity.