Weighted Average Cost of Capital (WACC) is defined as the weighted average of the cost of various sources of finance, weight being the market value of each source of finance outstanding. To balance financial risk, control over the company and cost of capital, a company usually does not procure entire fund from a single source, rather it makes a mix of various sources of finance. Hence, the cost of total capital will be equal to weighted average of cost of individual sources of finance.
Weighted Average Cost of Capital
WACC is also known as the overall cost of capital which includes the cost of different sources of capital as explained above. WACC of a company depends on the capital structure of a company. It weighs the cost of capital of a particular source of capital with its proportion to the total capital. Thus, the weighted average cost of capital is the weighted average after-tax costs of the individual components of a firm’s capital structure. That is, the after-tax cost of each debt and equity is calculated separately and added together to a single overall cost of capital
What does WACC Mean?
WACC (weighted average cost of capital) represents the investors’ opportunity cost of taking on the risk of putting money into a company. Since every company has a capital structure i.e. what percentage of funds comes from retained earnings, equity shares, preference shares, debt and bonds, so by taking a weighted average, it can be seen how much cost/interest the company has to pay for every rupee it borrows/invest. WACC can be calculated on the basis of Book Value (BV) weights or Market Value (MV) weights
Here cost of various sources means the return expected by the respective investors.
CIMA defines the WACC as “the average cost of company’s finance (equity, debenture, bank loans, etc.) weighted according to the proportion each element bears to the total pool of capital, weightage is usually based on market valuations, current yields and costs after tax.”
Traditionally, optimal capital structure is assumed at a point where WACC is minimum. For project evaluation, this WACC is considered as the minimum rate of return required from the project to pay off the expected return of the investors respectively, and as such WACC is generally referred to as the required rate of return. Accordingly, the relative worth of a project is determined using this required rate of return as the discounting rate.
The steps to calculate WACC is as follows:
Step 1: Calculate the total capital from all the sources of capital.
(Long-term debt capital + Pref. Share Capital + Equity Share Capital + Retained Earnings)
Step 2: Calculate the proportion (or %) of each source of capital to the total capital.
Equity Share Capital (for example) / Total Capital (as calculated in Step 1 above)
Step 3: Multiply the proportion as calculated in Step 2 above with the respective cost of capital.
(Ke × Proportion (%) of equity share capital (for example) calculated in Step 2 above)
Step 4: Aggregate the cost of capital as calculated in Step 3 above. This is the WACC.
(Ke + Kd + Kp + Ks as calculated in Step 3 above)
Example
Calculation of WACC
| Source of Capital | Cost of capital | % of total capital | Total |
| Retained Earnings | 10% (Kr) | 25% (Wr) | 2.50% (Kr × Wr) |
| Equity Share Capital | 11% (Ke) | 10% (We) | 1.10% (Ke × We) |
| Preference Share Capital | 9% (Kp) | 15% (Wp) | 1.35% (Kp × Wp) |
| Long term debts | 6% (Kd) | 50% (Wd) | 3.00% (Kd × Wd) |
| Total (WACC) | 7.95% |
The cost of weighted average method is preferred because the proportions of various sources of funds in the capital structure are different. To be representative, therefore, cost of capital should take into account the relative proportions of different sources of finance.
Formula
Simple WACC is calculated without considering the impact of tax on the cost of capital. In the case company is wholly financed by equity the cost of capital will be the cost of equity. Geared companies are the ones that are financed by debt also. In the case of geared companies, the WACC can be stated as follows:
WACC = (Cost of equity ´ % of equity) + (Cost of debt ´ % of debt)
WACC can also be calculated after considering tax shields as follows:
WACC = Ke ´ E / (D+E) + (1-T) ´ Kd ´ D / (D+E)
Where Ke is cost of equity capital,
Kd is cost of debt,
E is market value of equity capital,
D is market value of debt,
T is corporate tax rate.
In simple way it can be given as
WACC = (Cost of equity % of equity) + [Cost of debt (1-tax rate) % of debt].
We do the same because we get tax benefit of interest paid on loans. For details of the same, you can refer, https://caknowledge.com/deduction-in-respect-of-various-loans/. So if we do not consider the tax effect on debt, we will unnecessary be increasing the cost of debt, thereby the weighted average cost of capital.
Let us consider the calculation of WACC with the help of an example.
For example, a firm’s financial data shows the following:
- Equity = Rs. 800,000
- Debt = Rs. 200,000
- Ke = 12.5%
- Kd = 6%
- Tax rate = 30%
To find WACC, enter the values into the above equation and solve:
WACC = [{800,000 / (800,000 + 200,000)} * 0.125)] + [{200000 / (800,000 + 200,000)} * 0.06 * (1 – 0.3)]
WACC = 0.1 + .0084 = 0.1084 or 10.84%; the WACC for this firm will be 10.84%.
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