Weighted Average Cost of Capital - Explained
What is Weighted Average Cost of Capital?
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Table of ContentsWhat is Weighted Average Cost of Capital?Calculating the Weighted Average Cost of Capital (WACC)Formula Features ExplainedHow to calculate the cost of debtUses of Weight Average Cost of CapitalLimitations of Weight Average Cost Capital
What is Weighted Average Cost of Capital?
The weighted average cost of capital (WACC) commonly known as the company's cost of capital, is a method that investors use to assess their investments returns in a company. Debt and equity are two major components that make up a firms capital financing. This is where lenders and equity holders look forward to receiving returns on the money they have given to the company. The returns come from the company's cost of capital. When calculating returns, it is WACC that determines the number of returns that both parties will get. WACC represents the overall return needed for a company. The company directors, therefore, mostly use WACC to make decisions regarding the firm. The decision may include things such as economic possible mergers and opportunity for expansion. Firms operate their business on capital raised through different sources. WACC is the average of the costs of those sources of funding. All such capital comes at a cost in which each type varies from the other and proportionately weighted. Capital can be raised through the following sources:
- Common stock
- Preferred stock
- Taking commercial loans (long-term debt).
A firm can fund its assets through two main sources. It can be through debt or equity. You can be able to determine how much interest a company owes for each dollar it finances through weighted average.
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Calculating the Weighted Average Cost of Capital (WACC)
Calculation of WACC is done by multiplying the cost of each capital component (debt and equity) by its relevant weight. This is then added to the products to find the value. The formula for calculating WACC is expressed as below: WACC= (E/V x Re) + ((D/V x Rd) x (1-T) Where: Re= Cost of Equity (required rate of return) Rd= Cost of debt (yield to maturity on existing debt) E= Market value of the firms equity D= Maker Value of the firms debt V= Total value of capital (equity pul V= Total value of capital (equity + debt) E/V= Percentage financing that is equity D/V= Percentage of financing that is debt T= Tax rate
Formula Features Explained
- Cost of Equity
This refers to investment returns an investor is supposed to get from a company he or she has put money in. It is an important element of WACC, and useful for that person who wishes to invest in a company. Potential investors can use it as a point of reference when making an investment decision. However, this does not rule out the fact that equity has cost. In every company, the shareholders look forward to returns on their investments. If the company is unable to live up to the shareholders expectations, then, they may be forced to sell off shares. When this happens, the company's share price decreases and so does the company's value. To be able to maintain its share price and satisfy its investors, the company will have no choice but to spend some amount of its cost of equity. Note that share capital has no explicit value. For this reason, when a firm is offsetting its debt, it pays with a predetermined interest rate. In this case, the interest rate to be paid is depended on the debts size and duration.
- Cost of debt
The cost of debt is an essential part of WACC. It refers to the minimum rate a company pays on its current debt. The cost of debt helps you as an investor to understand the rate being paid by a firm for use in debt financing. Also, through the cost of debt, you are able to compare the risk level of different companies. For instance, a company with a high cost of debt becomes a risky venture for a potential investor.
How to calculate the cost of debt
To calculate the cost of debt, you first need to find out the total amount of interest the company is paying on each of its debts annually. To determine this, you will use the market rate which the firm is using to finance its debt. The figure can then be divided by the total amount of all of its debts. If the rate your company is paying is different from that of the market rate, then you should come up with an estimated suitable market rate to be used in your calculations instead. When a company is paying a debt, the interest paid is subject to a tax deduction. This is always beneficial to the company. Basically, the net cost of the company's debt is the amount of interest it pays, less the amount it has to save through tax-deductible interest payments. The after-tax cost of debt, this can be expressed as Rd (1-corporate tax rate).
Uses of Weight Average Cost of Capital
- WACC determines the returns the investors are supposed to get. This means that through it other potential investors are also able to find out whether or not investing in a particular company is worth it. They simply need to look at what the current investors have been getting from the company as returns. This way, they can be in a position to make their investment decision.
- When a weighted average cost of capital, it enables the company to calculate the actual cost of funding a project.
- WACC can be used by firms to determine the discount rate used in a discounted cash flow valuation model.
- WACC can also be used to measure the cost of capital to a company.
Limitations of Weight Average Cost Capital
Since some elements of WACC formula such as cost of equity, are inconsistent in value, those using it may bring out different reports in different seasons. This means that there is a possibility that figures from WACC may not be that reliable. One requires, therefore, using it along with other metrics when making an investment decision regarding a company.