Weighted Average Cost of Capital (WACC)

Concept

Weighted Average Cost of Capital (WACC) is a financial metric that calculates the average after-tax cost of the different types of capital a company uses for its operations, including equity and debt. The weighted part of WACC refers to the fact that each type of capital is proportionally weighted according to its usage in the company's capital structure.

WACC is widely used in finance for various purposes such as investment appraisal, capital budgeting, and valuation of companies. It represents the minimum return that a company must earn on its existing asset base to satisfy its creditors, owners, and other providers of capital.

Formula

The WACC formula is as follows:

$$\text{WACC} = \left( \frac{E}{V} \right) * R_e + \left( \frac{D}{V} \right) * R_d * (1 - T_c)$$

In this formula:

• $E$ represents the market value of equity - it can be calculated by multiplying the company's current share price by the total number of outstanding shares.
• $V$ is the total market value of equity and debt.
• $R_e$ is the Cost of Equity - it can be calculated using the Capital Asset Pricing Model (CAPM).
• $D$ represents the market value of debt - it can be calculated by adding together the company's short-term and long-term debt.
• $R_d$ is the Cost of Debt - this is the yield to maturity on the company's debt, which can be calculated based on the interest rate the company pays on its debt.
• $T_c$ is the corporate tax rate - this information is often available in the company's annual report or financial statements.

Each component of the formula represents a different aspect of a company's capital structure. The formula takes into account the proportion of capital that comes from equity ($E/V$) and debt ($D/V$), as well as the cost of each ($R_e$ and $R_d$). The corporate tax rate ($T_c$) is also factored in, as interest payments on debt are tax-deductible.

Practical Example

Assume we have the following data for a company:

• Market Value of Equity ($E$): $500,000
• Market Value of Debt ($D$): $500,000
• Cost of Equity ($R_e$): 12%
• Cost of Debt ($R_d$): 6%
• Corporate Tax Rate ($T_c$): 30%

Let's calculate the $\text{WACC}$ for this company:

1. $V$ = $E$ + $D$ = $500,000 + $500,000 = $1,000,000
2. $E/V$ = $500,000 / $1,000,000 = 0.5; $D/V$ = $500,000 / $1,000,000 = 0.5
3. Apply the WACC formula: $$\begin{aligned} \text{WACC} &= 0.5 * 12\% + 0.5 * 6\% * (1 - 30\%) \\ &= 6\% + 2.1\% = 8.1\% \end{aligned}$$

Hence, the $\text{WACC}$ for this hypothetical company is 8.1%.

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Takeaway

Understanding and calculating WACC is crucial in assessing investment decisions and company valuation. A firm's WACC is the overall required return for a firm, and it serves as a hurdle rate for new projects. If a project or investment doesn't meet this rate, it could be rejected. This manual serves as a fundamental guide in understanding the concept of WACC and its applications.