Weighted Average Cost of Capital (WACC)

The weighted average cost of capital (WACC) is a corporation's average after-tax cost of capital, which includes common stock, preferred stock, bonds, and other types of debt. The WACC is the average interest rate that a company plans to pay in order to finance its assets.

WACC is widely used to calculate the necessary rate of return since it expresses the return that both bondholders and shareholders need in order to provide the company with capital in a single value (RRR).. A company's WACC is likely to be higher if its stock is extremely volatile or if its debt is thought to be risky since investors will expect bigger returns.

WACC Formula and Calculation

The following is the formula for the weighted average cost of capital:

WACC=( E / V * Re ) + (D / V * Rd * ( 1-Tc) )

where:

  • E=Market value of the firm’s equity
  • D=Market value of the firm’s debt
  • V=E+D
  • Re=Cost of equity
  • Rd=Cost of debt
  • Tc=Corporate tax rate

The WACC is calculated by multiplying the cost of each capital source (debt and equity) by the appropriate weight, and then adding the resulting products. In the formula above, E/V represents the percentage of equity-based financing, whereas D/V represents the percentage of debt-based financing.

Hence, the WACC formula requires the addition of two terms:

( E / V * Re)

( D / V * Rd * ( 1 - Tc) )

In the former, the weighted value of stock capital is represented, whereas in the latter, the weighted value of debt capital.

Let's say a business sold common shares to raise $4 million in equity and $1 million in debt financing. Both E/V and D/V would be equal to 0.8 ($4,000,000 $5,000,000 of total capital) and 0.2 ($1,000,000 $5,000,000 of total capital), respectively.

WACC Vs. Required Rate Of Return (Rrr)

The lowest rate an investor will take for a project or investment is known as the required rate of return (RRR). They will allocate their funds in other places if they anticipate a lower return than what they need.

The CAPM, which projects the return that stockholders would need based on the volatility of a stock in relation to the overall market (its beta), is one method for calculating the RRR.

Calculating WACC is another approach for determining the RRR. The benefit of employing WACC is that it considers the capital structure of the company, or how much it relies on debt financing as opposed to stock.

Limitations Of WACC

It is more difficult to calculate the WACC formula than it appears. Different parties may report the formula's components differently for various reasons since some of them, such as the cost of equity, may not have consistent values.

If you are unfamiliar with all the inputs, it may be challenging to compute the WACC. Greater debt levels imply higher WACC requirements from the investor or company.

Moreover, WACC is not appropriate for accessing hazardous projects because the cost of capital will be greater due to the higher risk. Investors may choose to use adjusted present value (APV), which does not employ WACC, as an alternative.

Conclusion

The weighted average cost of capital (WACC), which gives each category of capital a proportional weight, serves as a proxy for a company's cost of capital.

Businesses and investors sometimes use the WACC as a benchmark rate to assess the viability of a particular project or acquisition.

For calculating WACC, the cost of each capital source (debt and equity) is multiplied by the relevant weight by market value, and the results are added up to reach the final result.

The WACC is occasionally used as the discount rate for future cash flows in discounted cash flow analyses.

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