Definition of WACC
The Weighted Average Cost of Capital (WACC) refers to a firm’s average cost of finance from all sources including equity, preferred shares, and debt. It can also be defined as the average rate of return that is expected to be paid to stakeholders, debt holders, and preferred shareholders. Another definition of WACC is: the weighted average cost of a company’s equity and debt. One of the assumptions of the WACC is that the market for debt and equity requires a rate of return that reflects the investment risks of the company.
Example: Suppose a company’s CEO goes to the bank and requests for a loan. The company agrees to lend the money at an interest rate of 10%, which means the firm has to pay an interest above the principal amount borrowed. This is called “cost of capital or cost of debt.” When the company grows, the company decides to offer shares to investors to raise additional funds. The firm has to pay dividends and flotation costs incurred through shares. This is also part of the cost of capital, and is known as cost of equity. A company that has more than one source of capital needs to calculate the weighted average cost of capital.
Formula for Calculating WACC
The Weighted Average Cost of Capital can be calculated as follows:
WACC Formula = (E/V × Re) + (D/V) × Rd × (1 – Tax rate); where:
- E = Market Value of Equity
- V = Total market value of equity & debt
- Re = Cost of Equity
- D = Market Value of Debt
- Rd = Cost of Debt
- Tax Rate = Corporate Tax Rate
Components of WACC
Based on the formula above, the components of the WACC are as follows:
- The market Value of Equity refers to the total value of shares offered by the company. for example, if a company has 10,000 shares, each valued at a market value of KSH5, the market value of the company’s equity is 10,000 × KSH 5 = KSH 50,000.
- The market value of debt is the total amount of debt that the company has borrowed from various sources.
- Adding the market value of debt and market value of equity gives us the total market value of equity and debt.
- Cost of equity: the minimum return that shareholders demand. It refers to the cost of leveraging financial capital or equity provided by shareholders, which are repayable in capital gains and higher share price. The cost of equity can be determined using the dividend price approach or the earning price approach.
- Cost of debt: This is the cost incurred when borrowing funds from a bank or financial institution for investment purposes. The financing institution recovers its principal amount and earns profit by charging interest on the borrowed amount. This interest contributes to the total cost of debt.
- Corporate Tax Rate: The cost of debt needs to be adjusted to reflect that interest payments are tax-deductible. A company’s tax rate is primarily determined by where it operates.
Example of Calculating WACC
Assume Company A has a market value of debt of KSH 1 million and market value of equity (market capitalization) of KSH 4 million. Further assume that the cost of equity is 10%, cost of debt is 5%, and tax rate is 25%; calculate the WACC.
WACC = (E/V × Re) + [(D/V) × Rd × (1 – Tax rate)];
First calculate V (the total market value of debt and equity):
V = 4 million + 1 million = KSH 5 million.
WACC = [(4/5 × 0.1)] + [(1/5) × 0.05 × (1-0.25)]
WACC = 0.08 + 0.0075
WACC = 0.0875 or 8.75%
To interpret this, the company needs a minimum rate of return of 8.75% from its investments to be able to give returns to finance providers.
NB: The first part of the formula represents the weighted average cost of equity (E/V × Re); while the second part represents the weighted average cost of debt [(D/V) × Rd × (1 – Tax rate)]. When you add the two parts you get the weighted average cost of capital (WACC).
Uses of WACC
There are several uses or importance of WACC in a company.
- WACC is used as the discount rate when calculating the net present value (NPV). This means that it is used in financial modelling.
- Used as the hurdle rate when analyzing investment projects
- Used to calculate a company’s opportunity costs
- Used to make dividend decisions – whether to pay dividends to shareholders or not.
- Calculation of the economic value added (EVA)
- WACC is also used for the valuation of the company
- It is used to create optimal capital budgets.