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Analyzing the cost of invested capital. Explanation of WACC. Weighted Average Cost of Capital.

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:

1. Calculating this risk premium is one thing that makes the calculation of WACC complicated.
2. Another important complication is which mix of debt and equity should be used to maximize shareholder value. This is what "Weighted" means in WACC.
3. 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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