If time value of money is the heart of finance then the weighted average cost of capital is the component that comprises the soul of this realm. In order to understand the fundamental assumptions and uses of the weighted average cost of capital, let’s begin with what comprises the cost of capital.
Cost of Capital
Every dollar used to finance a project comes at a cost. If you use debt, the cost is the interest you must pay to the lender. If you use your own money, the cost is the return you could have earned from doing something else with the money. This is referred to as the cost of capital.
Sources of Capital
A company can have multiple sources of capital: Common Equity, Preferred Equity, Debt, Convertible Debt, Warrants, etc. to name a few. For simplicity, they are classified into broader categories of Equity and Debt. The weighted average of the required returns of these sources of capital that are used to finance the company is essentially the WACC.
Having read the aforementioned explanation of WACC, a plausible question would then be what is the effect of a company’s riskiness on WACC? Well, WACC is affected by the riskiness of a company in two ways. If the company holds significant market risk, the required rate of return on the debt and equity securities issued by the company will be higher and the risk would influence how it chooses the extent to which it is financed by debt and equity (the mix between the two).
Weighted Average Cost of Capital = E*KE + D* KD* (1-T)
- E is the percentage of financing that is equity
- KE is the cost of equity
- D is the percentage of financing that is debt
- KD is the cost of debt
- T is the tax rate
Tax Implications of Debt
The equation above shows that the debt component was factored for tax rate. This is because having debt provides a tax shield. The equation is thus adjusted for the effects of taxes because interest is tax deductible.
Applications of WACC
- In Discounted Cash Flow analysis, WACC is used as the discount rate to compute the present value of future cash flows.
- Starting point in determining the discount rate for investments the company may undertake
- Company performance evaluation in order to speculate if it has created value for its shareholders
In a nutshell, in order to estimate a firm’s WACC, a good rule of thumb is to break it down into three components:
- Define the capital structure of the company.
- Estimate the cost of capital for each of the sources of financing.
- Calculate a weighted average of the costs of each source of financing.
A helpful tip that serves as a check to your estimation of WACC is that the average you calculate should fall between the after-tax cost of debt and the required rate of return from the common stockholders.blog comments powered by Disqus