What is the WACC? Definition
Corporations create value for shareholders by earning a return on the invested
capital that is above the cost of that capital. WACC (Weighted Average
Cost of Capital) is an expression of this cost. It is used to see if value
is added when certain intended investments or strategies or projects or purchases
are undertaken.
WACC is expressed as a percentage, like interest. For example, if a company
works with a WACC of 12%, than this means that only investments should
be made and all investments should be made, that give a return higher
than the WACC of 12%.
The costs of capital for any investment, whether for an entire company
or for a project, is the rate of return which capital providers would want
to receive if they would invest their capital elsewhere. In other words, costs
of capital are a type of opportunity cost.
Calculation of WACC. Formula
The easy part of WACC is its debt part. In most cases it is clear how much
a company has to pay their bankers or bond holders for debt finance. More
difficult however, is the cost of equity finance. Normally, the cost of equity
capital is higher than the cost debt finance, because equity involve a risk
premium. See also: Cost of Capital.
Factors that make calculating WACC difficult:
- Calculating this risk premium is one thing that makes the calculation
of WACC complicated.
- Another important complication is which mix of debt and equity
should be used to maximize shareholder value. This is what "Weighted" means
in WACC.
- Finally: also the corporate tax rate is important, because normally
interest payments are tax deductible.
The WACC formula:
Debt / TF (cost of debt)(1-Tax)
+ Equity / TF (cost of equity)
-------------------------------------------------
WACC
In this formula,
- TF means Total Financing. Total Financing consists of the sum
of the market values of debt and equity finance. An important issue with
TF is whether, and under what circumstances, it should include current liabilities,
such as trade credit. In valuing a company this is relevant, because:
- Trade credit is used aggressively by many companies.
- There is an interest (or financing) charge for such use.
- Trade credit can be a large amount on the balance sheet.
- Tax stands for the corporate tax rate.
Example of WACC calculation.
Suppose the following situation in a company:
The market value of debt = €300 million
The market value of equity = €400 million
The cost of debt = 8%
The corporate tax rate = 35%
The cost of equity is 18%
The WACC of this company is:
300 : 700 * 8% * (1-35%)
+ 400 : 700 * 18%
------------------------------------------------
12,5% (WACC - Weighted Average Cost of Capital)
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Compare with WACC: Cost
of Capital | Internal Rate of Return
| Net Present Value |
Discounted Cash Flow |
Cost of Equity
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