The weighted average cost of capital (WACC) is the rate expected to be calculated by a company in which each category of capital is weighted proportionately.
Different types of sources that are included in the WACC calculation are bonds, common stock, preferred stock, warrants, options, and other long-term debts.
When calculating the present value of the project analysts use the WACC formula in financial modeling as the discount rate.
The WACC formula shows the relationships between the components of capital, equity and debt. The formula is:
WACC = E/ (E+D) * RE D/ (E+D) * RD * (1-T)
E = The market value of equity
D = The market value of debt
RE = The rate of return on equity
RD = The cost of debt
T = The tax rate
Advantages of WACC
The WACC is an important part of the Discounted Cash Flow (DCF) model and it’s a vital concept for finance professionals. It helps by giving a minimum rate a company should earn on its asset base to satisfy its stakeholders.
Companies incur many types of costs and they want to reduce the costs. WACC suggests the costs companies incur on their capital that can be either debt or equity.
WACC helps companies to increase their value because the lower the WACC, the higher will be the value of the firm.
- WACC can be a measure for comparing similar business risks. It helps a company to know which corporation is incurring minimum costs in using its capital. The business risk indicates the possibility of generating less than the required profit. The business risk varies from industry to industry. When a company has lower WACC compared to other companies in the same kind of industry, it means it can create more value for its stakeholders.
- WACC helps companies to make judgement whether to accept or reject a new project. To decide whether to accept or reject a project the IRR is compared with the cost of capital of the company.
- As the WACC is the minimum rate a company should generate to meet the expectations of its stakeholders, so it acts as the hurdle rate for companies which they need to cross to generate values.
- When evaluating mergers and acquisitions and preparing financial models the WACC is of great importance. Investment decisions should not be made when an IRR is below the WACC.
Analysts very often use the WACC to assess the value of investments and to choose from different types of investment opportunities. The WACC is an indicator of whether an investment decision should be made or not.
If it is required to determine an investor’s personal return on an investment, the WACC should be subtracted from the company’s returns percentage. The WACC is also important in performing Economic Value-Added calculations.
The WACC help in determining the amount of interest a company owes for each dollar it invests. A company’s capital funding comprises of debt and equity. Debt and equity holders expect a certain amount of return on the capital they have provided.
The WACC indicate the return that both debt and equity holders expect to receive because the cost of capital is the return that both equity and debt holders expect to receive.
In another sense, WACC is the opportunity cost for an investor for taking the risk of investing funds in a company. A company’s WACC is the overall required return for a company.
For this reason, company directors often internally use WACC to decisions on different types of expansionary opportunities. The WACC is the discount rate that is used for cash flows for the risk that similar to the other business risks.
WACC is a metric that assists in the percentage distribution of costs for different amounts from different sources. A company that wants to reduce its WACC may look into cheaper source of finance.
For example, it can issue more bonds rather than stocks as it will be a more affordable option. This will cause an increase in the debt to equity ratio as debt is cheaper than equity and ultimately the WACC will decrease.
Companies need to know their WACC because they need to identify which costs to reduce and analyze new investment projects.
The WACC also provides a good way to explain the capital structure of a company and identify a good proportion between various kinds of financing sources. The lower the WACC, the better it is for a business to make further investment decisions.