Weighted average cost of capital of a company is determined as the weighted average of a company’s cost of equity and cost of debt blended together. In finer terms, it represents the rate of return that a project must have in order to attract investors to invest capital. WACC is also termed as cutoff rate or minimum rate of return or financing rate of return.
WACC depends on the capital structure of a company. If a company is financed solely through equity, then weighted average cost of capital will be equal to the cost of equity.
However in general, a company is financed in combination of both equity and debt. Debt capital is the money given as a loan to the business with the understanding that it must be paid back within a predetermined period. Equity capital is the money owners have contributed in exchange of shares plus the retained earning. You can find both equity and debt capital in company’s balance sheet.
To find out WACC, we have to find out cost of debt and cost of equity separately and then add them together.
Cost of debt is the interest rate paid by the company on its debt. Interest is tax deductible, as such by paying interest you are also saving tax so the interest should be considered net of tax. Therefore, cost of debt is calculated as follows:
Interest expenses (1-tax rate) / total debt
Cost of equity is determined based on the expectations of the equity capital holders. In other words, its the rate of return required by company’s common stockholders. As there is no fixed obligations to pay equity shareholders, cost of equity can be calculated by the capital asset pricing model (CAPM) as follows:
CAPM = risk free rate of return + beta (market rate of return – risk free rate of return)
Beta is known as estimation of risk. You can use historical stock prices to calculate beta.
Instead of using CAPM, you can use dividend discount model approach to calculate cost of equity.
Weighted Average Cost of Capital = {Interest expenses (1-tax rate) / total debt} + {risk free rate of return + beta (market rate of return – risk free rate of return)}
Importance of weighted average cost of capital or WACC
Capital is the money that the business uses to fund its expansion such as purchase of assets or new project. Therefore, it’s important to understand the impact of these capital on projects profitability.
To earn profit out of a project, you need to make sure that the project’s investment rate of return must be equal or exceed its financing rate of return. In general, management will invest in those companies which provide returns more than the company’s WACC.
Below is a list of few cases where a company uses WACC;
- To judge whether a capital budgeting decision worth the risk compared to the return.
- To discount future cash flows from potential projects to estimate net present value (NPV).
- To know whether the project will create value for the company or destroy it. To create value, the project must generate return in excess of company’s WACC.
- To evaluate company’s investment options.
- To appraise the performance of specific projects by comparing its rate of return with WACC.
