WEIGHTED AVERAGE COST OF CAPITAL: WHAT IT IS FOR, CALCULATION - DUDAS - 2024

The weighted average cost of capital is the rate that a company is expected to pay on average to all of its security holders to finance its assets. Importantly, it is dictated by the market and not by management.

The weighted average cost of capital represents the minimum return that a business must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital.

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Companies obtain money from various sources: common stock, preferred stock, common debt, convertible debt, exchangeable debt, pension obligations, executive stock options, government subsidies, etc.

These different securities, representing different sources of financing, are expected to generate different returns. The weighted average cost of capital is calculated taking into account the relative weights of each component of the capital structure.

Since the cost of capital is the return that equity owners and debt holders expect, the weighted average cost of capital indicates the return that both types of stakeholders expect to receive.

What is it for?

It is important for a company to know its weighted average cost of capital as a way to measure financing expense for future projects. The lower a company's weighted average cost of capital, the cheaper it will be for the company to finance new projects.

The weighted average cost of capital is the total return required by a business. Because of this, company directors often use the weighted average cost of capital to make decisions. In this way they can determine the economic feasibility of mergers and other expansionary opportunities.

The weighted average cost of capital is the discount rate to use for cash flows with similar risk to the firm.

For example, in discounted cash flow analysis, you can apply the weighted average cost of capital as the discount rate for future cash flows to obtain the net present value of the business.

Critical rate of return

The weighted average cost of capital can also be used as a critical rate of return against which companies and investors can evaluate return on investment performance. It is also essential to perform economic value added (EVA) calculations.

Investors use the weighted average cost of capital as an indicator of whether an investment is profitable.

Simply put, the weighted average cost of capital is the minimum acceptable rate of return at which a company must produce returns for its investors.

How is it calculated?

To calculate the weighted average cost of capital, the cost of each capital component is multiplied by its proportional weight and the sum of the results is taken.

The method for calculating the weighted average cost of capital (WACC) can be expressed in the following formula:

CCPP = P / V * Cp + D / V * Cd * (1 - Ic). Where:

Cp = cost of equity.

Cd = cost of debt.

P = market value of the company's equity.

D = market value of the company's debt.

V = P + D = total market value of the financing of the company (equity and debt).

P / V = ​​percentage of financing that is equity.

D / V = ​​percentage of financing that is debt.

Ic = corporate tax rate.

Formula elements

To calculate the weighted average cost of capital, it must be determined how much of the company is financed with equity and how much with debt. Then each one is multiplied by its respective cost

Cost of equity

The cost of equity (Cp) represents the compensation demanded by the market in exchange for owning the asset and assuming the risk of ownership.

Since shareholders expect to receive a certain return on their investments in a company, the rate of return required by shareholders is a cost from the company's point of view, because if the company does not deliver the expected return, the shareholders will simply sell their shares. Actions.

This would lead to a decrease in the share price and the value of the company. So the cost of equity is essentially the amount a company must spend to maintain a share price that satisfies its investors.

Cost of debt

The cost of debt (Cd) refers to the effective rate that a company pays on its current debt. In most cases, this means the cost of the business's debt before taxes.

Calculating the cost of debt is a relatively straightforward process. To determine this, the market rate that a company is currently paying on its debt is used.

On the other hand, there are tax deductions available on interest paid, which benefit businesses.

Because of this, the net cost of debt for a business is the amount of interest it is paying, minus the amount it has saved in taxes, as a result of tax deductible interest payments.

This is why the after-tax cost of debt is Cd * (1-corporate tax rate).

Example

Suppose that the new ABC Corporation needs to raise $ 1 million of capital in order to purchase office buildings and the equipment necessary to run its business.

The company issues and sells 6,000 shares at $ 100 each to raise the first $ 600,000. Because shareholders expect a 6% return on their investment, the cost of equity is 6%.

The ABC Corporation then sells 400 bonds for $ 1,000 each to raise the other $ 400,000 of equity. The people who bought those bonds expect a 5% return. Therefore, ABC's cost of debt is 5%.

The total market value of the ABC Corporation is now $ 600,000 of equity + $ 400,000 of debt = $ 1 million and its corporate tax rate is 35%.

Calculation

Now you have all the ingredients to calculate the weighted average cost of capital (WACC) of the ABC Corporation. Applying the formula:

CCPP = (($ 600,000 / $ 1,000,000) x 6%) + = 0.049 = 4.9%

The weighted average cost of capital of the ABC Corporation is 4.9%. This means that for every $ 1 that ABC Corporation obtains from investors, it must pay them almost $ 0.05 in return.

References

1. Investopedia (2018). Weighted Average Cost of Capital (WACC) Taken from: investopedia.com.
2. Wikipedia, the free encyclopedia (2018). Weighted average cost of capital. Taken from: en.wikipedia.org.
3. Investing Answers (2018). Weighted Average Cost of Capital (WACC). Taken from: investinganswers.com.
4. CFI (2018). WACC. Taken from: corporatefinanceinstitute.com.
5. Wall Street Mojo (2018). Weighted Average Cost of Capital - Formula - Calculate WACC. Taken from: wallstreetmojo.com.