WACC is an essential part of the DCF valuation model and it is important to understand the concept of Weighted Average Cost of Capital for finance professionals relating to investment, banking and corporate development.
Weighted Average Cost of Capital of a firm represents the mixed cost of capital from all the sources, including debt, common shares, and preferred shares. Each type of the cost of capital is weighted by the percentage of total capital and all are added together.
Weighted Average Cost of Capital is used for financial modelling as a discount rate to assess the net present value (NPV) of a business.
The following diagram denotes each category of the capital is proportionately weighted as under:
E represents the market value of a firm’s equity.
D represents the market value of a firm’s debt.
V means total value of capital (equity plus debt).
E/V represents a percentage of capital (equity).
D/V means a percentage of capital (debt).
Re represents the cost of equity i.e. required rate of return.
Rd represents the cost of debt i.e. yields to maturity on the existing debt.
T is the tax rate.
Formula of an Extended Version WACC for Companies:
The purpose of the Weighted Average Cost of Capital is to determine each proportion of capital structure of the company i.e. cost of equity, cost of debt, and the preferred stock. The company is liable to pay a fixed interest rate on its debt as well as a fixed yield on the preferred stock. No firm is liable to pay the fixed rate of return on the common equities. In case of surplus, it does pay dividends to the equity holders in the form of cash.
Cost of Equity (Re):
The cost of equity does not have any particular price that a company must pay. But it does not mean that the Cost of Equity (Re) is zero.
The shareholders would receive a certain amount of return on their investments. The required rate of return of an equity holder is an amount of share that can be earned by the selling of share if the company fails to comply with the expected rate of return with their shareholders. This will lead to a sharp decrease in the price of a share as well as the company’s value.
The cost of equity is an integrated amount that a company must have to spend in the share in order to maintain its price that will definitely satisfy its investors.
Cost of Debt (Rd):
Cost of Debt is a straightforward process. The determination of the cost of debt is based on the idea of current pay-off of debts by the company. If the company’s pay-off rate is different from the market rate then this can assess an appropriate market rate.
The tax deductions are available on the interest paid. Often these taxes are considered as the companies’ benefit. The reason for consideration is that the net cost of debt is the pay-off of interest amount, minus (-) those amounts that have saved in the form of taxes. As a result, it gains tax-deductible from the interest payments. That’s why the cost of debt after-tax is considered as:
Rd (1 – Corporate Tax Rate)
The risk-free rate refers to the return which is earned by investing in the riskless securities.
For example: U.S. Treasury Bonds. The risk-free rate is considered as the yield of the 10-year of this bond.
Equity Risk Premium (ERP):
Equity Risk Premium refers to the extra yield that the security can be earned over the risk-free rate in the stock market.
Equity Risk Premium can be estimated by subtracting the risk-free return from the market returns. This information would be enough for a basic financial analysis. However, estimating Equity Risk Premium can be a more complex task.
Uses of Weighted Average Cost of Capital:
- Securities analysts mostly used Weighted Average Cost of Capital for assessing the investments’ value and determine that which ones to pursue. As an example, the discounted cash flow analysis, and one could Weighted Average Cost of Capital apply as a discount rate for the future cash flows to derive the net present value for a business.
- Weighted Average Cost of Capital can also be used to measure a hurdle rate of invested capital in terms of ROIC (return on invested capital) by the companies and investors.
- Weighted Average Cost of Capital is essential to use in order to exercise the economic value-added calculations.
- Investors may use Weighted Average Cost of Capital as an indicator of investment whether to pursue the investment or not.
- Weighted Average Cost of Capital is a minimum accepted rate of return of investors by which a company yields returns.
- To calculate the personal returns of an investor in a company for a single investment, simply subtract the Weighted Average Cost of Capital from the percentage of that company’s returns.
Cost of Capital v/s Rate of Return:
The cost of capital refers to what a company expects from the securities in terms of returns. Meanwhile, the rate of return is related to the investor’s perspective i.e. the minimum rate at which an investor will accept the return from a project or investment.
Limitations of Weighted Average Cost of Capital:
The WACC has a complex calculation though it might easy. Some elements of the Weighted Average Cost of Capital, like the cost of equity, are not consistent in their values. Few companies report them differently for different reasons. Weighted Average Cost of Capital can often help in lending valuable insights into a company. It should be always used with other metrics while determining the investment.