What is the Weighted Average Cost of Capital?
Whereas cost of equity only takes into account equity investments, WACC combines equity and debt. Because the cost of debt is usually lower than that of equity, a business’s WACC will usually work out lower than just the cost of equity. Therefore, it is considered a discounted rate.
It is used to calculate that business’s net present value and by investors to determine the hurdle rate of a potential investment. It can also determine the present value of an individual project or business undertaking.
Weighted cost of capital formula
The formula for WACC uses market values, rather than book values, of a business’s debt and equity.
Cost of debt is the total annual interest repayments divided by the total debt.
Cost of equity uses the capital asset pricing model formula. It can be determined by using the minimum return that investors expect to receive. Alternatively, you can use the dividend discount calculation.
What is weighted average cost capital used for?
The weighted average cost of capital is used to calculate that business’s net present value and by investors to determine the hurdle rate of a potential investment. It can also determine the present value of an individual project or business undertaking.
One of the benefits of WACC is that it is a market determined value and is not determined or effected by the management team or the organization itself, other than through genuine efforts to reduce costs of capital.
- Net present value (NPV) – The net present value is the difference between present cash inflow and outflows. It is used to determine how profitable a venture or investment will be. It relies on a discount rate to discount future cash flows to a current rate. WACC can be used as a reliable and accurate discount rate for NPV calculation.
- Opportunity cost – For the investor, WACC is the opportunity cost of investing in a company. By investing in the company, this is the amount of cash the investor misses out on.
- Hurdle rate – A hurdle rate is the minimum return required by an investor or finance manager to invest in an opportunity. If returns fall below this rate, investors will likely cash out and it will be difficult to attract new investors.
The weighted average cost of capital is quick and easy to apply. The figures required are relatively easy to find out, primarily because they use market values.
Its simplicity and the fact that it derives a single hurdle value means that WACC allows for swift and lean decision making.
Although WACC can be easy to calculate, it becomes increasingly complicated and difficult to calculate as more sources of capital are added. As a result, it is common to ignore or miss certain capital sources like trade credit or puttable bonds. While missing these forms of capital makes the calculation easier, it leads to an imprecise WACC.
It can be difficult to acquire a market value of capital sources. For example, interest rates change frequently and will change over the course of the next year. Expected dividends also change frequently.
The WACC is a measure of all costs of capital a company has, including equity and debt sources. Each source is weighted according to market value, with the total figures combined to give an overall value.
The weighted cost of capital can be used as a hurdle rate, to calculate net present value, or as an opportunity cost by investors. It is considered quick and easy to determine, although it does become more complex the more sources of capital an organization has.