WACC is the rate used to discount the future cash flows and terminal value to get present value. It is the return expectations of all providers of capital including debt and equity holders for investing in a project. It is also known by different names such as firm’s cost of capital, opportunity cost of capital, discount rate and these terms are used interchangeably.
It tells how much it cost a company to acquire capital from different sources. Generally, two kinds of people provide capital to the business one who purchase the stocks of the company and another who issues loan to the company. Company always try to earn a return more than the cost of capital to meet investors expectations and provide them good return.
Steps to calculate WACC:
1. Calculate the cost of debt: To calculate cost of debt simply take the amount of money borrowed and see the interest rates that company is paying.
2. Determine the Tax Rate.
3. Calculate the cost of equity: To calculate cost of equity, capital asset pricing model (CAPM) is generally used. CAPM works on 3 inputs i.e. risk-free rate, beta, equity risk premium. Formula to calculate cost of equity: Risk Free Rate of Return + Beta * (Market Rate of Return – Risk free Rate of Return)
- Risk free rate: It is the return investor would get on risk less investments such as T-bills. Government Bond are considered as a proxy for risk free rate.
- Beta: Beta is a measure of risk in a company as compared to market.
- Equity Risk Premium: The equity risk premium is the extra return investor expect for shifting their money from a risk-free investment to a risky project.
4. Select weight of debt and equity in the capital structure.
5. Calculate a WACC range.
The weighted average cost of capital (WACC) is determined by the Ke (Cost of Equity) and Kd (Cost of debt), weighted by the market value of their share in entire capital.
WACC= Ke * (% Equity) + Kd* (% Debt) * (1 – T) + Kp* (% Preferred)
Where, Ke is the “Cost of Equity”, Kd is the “cost of debt”, Kp is the “cost of preferred”, and T is for “corporate tax rate”
Tax Shield on debt
Company will receive tax advantages of having debt in the capital structure. As interest payments are tax deductible thus result in lower tax bill. Heavy amount of debt in the capital structure to enjoy tax benefit leads to bankruptcy. Heavy debt gives a warning signal to the company and gives indication to reduce debt component from the capital structure to save the company from bankruptcy.
Uses of WACC:
- It is used to assess investment opportunities and risk.
- It is used to evaluate whether to invest in a project or not. If internal rate of return is greater than WACC then it is considered good to invest in a project, if returns are less than cost of capital or WACC then it is suggested not to invest in that project.
- It also helps the companies to decide and design the optimal capital structure.
An intelligent company will only invest in those projects where company expected rate of return is greater than the cost of capital. If the company is investing in a project where returns are low, then the company is encouraging the investor to go and invest elsewhere.
Disadvantages of WACC
- Capital Structure (Debt/Equity ratio) remains constant forever to estimate future WACC. When forecasting the value of the firm. Assuming constant capital structure throughout is impossible.
- Adding more debt in the capital structure to lower the WACC increase the cost of financial distress.
Example of WACC:
Let’s suppose, the company finances its business with 30% debt and 70% equity. Where beta = 1, risk free rate = 2%, market rate = 11%, Interest on debt is 6% and 27.5% as the tax rate. Calculation of WACC:
First step is calculate Cost of equity: Risk free rate (2%) + Beta (1) * Equity Risk Premium (11% – 2%) = 11%
Cost of Debt: Average interest cost of debt (6%) * (1- 27.5%) = 4.35%
Final Calculation: (Debt% * Cost of Debt) + (Equity% * Cost of Equity) = (0.3*4.35%) + (0.7*11%) = 9.01%
WACC acts as a key driver in almost every valuation. Selection of right percentage of debt and equity ratio in the capital structure is very important. It can increase or decrease the valuation therefore right selection of discount is needed. It helps the companies in deciding which project to pursue or not to pursue.
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