The weighted average cost of capital of a company is the cost of capital of all its equity and debt instruments proportionately weighted.
These instruments may include common shares, preferred shares, and debt instruments of a company. The cost of capital is the required rate of return of a company on any project.
The cost of capital of equity and debt instruments of a company can easily be found through different methods and models; however, the company can only use one rate of return when evaluating its investments. This is because the company does not use only one source of finance for these projects.
To finance a project, the company uses a mix of equity and debt finance. Therefore, it is difficult to associate a specific project with a specific source of finance and the weighted average cost of capital of all sources of finance is considered instead of one the cost of capital of one particular source of finance.
The weighted average cost of capital is a useful tool for companies as it allows companies to calculate the net present value of different projects. The concept of WACC is also easy to grasp and can be simply calculated by the management of the company.
Once the WACC of a company is calculated, the WACC is used throughout the company’s project evaluations to identify if those projects are feasible for the company. This allows companies to make faster decisions regarding the feasibility of a project, so every opportunity is available at the right time.
While the weighted cost of capital is a useful tool, it can have some problems. To calculate the weighted average cost of capital of a company, the company must make a few assumptions.
These assumptions are that there will be no change in the capital structure of the company and no change in its risk with the inclusion of a new project. It’s difficult for companies to maintain these assumptions. The WACC also only takes into account the long-term capital of a company and, therefore, may neglect the costs associated with the short-term sources of capital.
Weighted Average Cost of Capital Assumptions
There are some assumptions that must be made and must be true in order for the weighted average cost of capital of a company to be calculated and used for project evaluation.
If these assumptions are not true, the weighted average cost of capital cannot be reliably calculated. Every time there is a change in these assumptions, the company must calculate a new weighted average cost of capital. The assumptions are as follows:
- WACC assumes that the capital structure of a company does not change with the start of the new project. For example, if a company has a WACC of 12% with a 75:25 equity-to-debt ratio, the company must assume that after the project is started, the capital structure and the WACC will remain the same. If this assumption is not made, the current WACC cannot be used to evaluate the project.
- WACC also assumes that the risk of the new project is the same as the risk of its current projects. This assumption can be easily made for projects within the normal nature of the company’s business, however, may prove unreasonable for projects outside of the normal scope of the company’s business. For example, if a smartphone company is evaluating a new smartphone technology project, the risks associated with the project may be inline with the company’s current risks but if the company considers investing in a computer technology project, the risks may be completely different.
Weighted Average Cost of Capital Formula
The WACC of a company can be calculated using the formula below:
WACC = [Ve / (Ve + Vd)]ke + [Vd / (Ve + Vd)]kd(1-T)
Ve and Vd are the values of equity and debt instruments of the company respectively.
Ve + Vd is the total value of a company’s financing.
Ke is the cost of equity of a company.
Kd is the cost of debt of a company. However, this cost of debt is taken after deducting Taxes from it, also known as the post-tax cost of debt of a company. The tax rate is the corporate tax rate of the company.
A company can calculate its weighted average cost of capital using the steps below:
- Calculate the weight of each equity and debt instrument. Companies can use different valuation methods to calculate the weight of these instruments, for example, the market value or book value of the instruments. However, market values should always be preferred to book values whenever possible.
- Calculate the cost of all the equity and debt instruments. Cost of equity and cost of debt can be calculated using models such as Capital Asset Pricing Model (CAPM) or Dividend Capitalization Model (DCM).
- Once the weight and cost of instruments are known, calculate the value of the instruments by their weights to calculate the total value of the instruments.
- Finally, sum the results obtained from the above step to obtain the weighted average cost of capital.
A company ABC Co. has 120,000 issued common equity shares quoted at $50 per share in the market, 50,000 preference shares quoted at $40 per share and $2 million debt instruments in issue.
The cost of capital of these instruments are 17%, 13% and 12% respectively. The corporation tax percentage of the company is 25%. The weighted average cost of capital using the above formula can be calculated as follows:
The total capital of the company is the sum of the values of its common shares, preference shares and debt instruments (Ve + Vp + Vd). This is calculated to $10 million ($6 million common shares value (120,000 shares x $50) + $2 million preference shares value (50,000 x $40) + $2 million debt instruments).
Now the formula can be written as follows to include the preference shares of the company in the equation:
WACC = [Ve / (Ve + Vp + Vd)]ke + [Vp / (Ve + Vp + Vd)]kp + [Vd / (Ve + Vp + Vd)]kd(1-T)
Putting the values in the formula above, the formula can be written as:
WACC = [$6m / $10m]17% + [$2m / $10m]13% + [$2m / $10m]12%[1-25%]
WACC = [60%]17% + [20%]13% + [20%]7%
This will give the company a weighted average cost of capital of 14.2%. The company can use 14.2% as rate of return to evaluate any projects.
The weighted average cost of capital of a company is the average cost of capital for all its finance sources weighted on its total capital.
The weighted average cost of capital can be used by companies to find an average rate of return to evaluate upcoming projects. The calculation of the weighted average cost of capital can be done through a formula in 4 easy steps.