Weighted Average Cost of Capital is the estimation of a firm’s cost of capital considering every source that there is. This includes the cost of equity, the cost of debt, and the cost of preferred shares.
Published on 24 February 2023
It is the standard rate that a firm may have to pay for the management of its financial assets. The formula for calculating this is-
WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))
So, the weighted average of the total cost of everything that is involved in possession of the firm’s capital is calculated by WACC. As a result, it is a form of a financial ratio. This makes it accountable for the total expenses of a company. This may include the expenses of a firm when it is making a staunch decision to invest.
The method is also useful for analyzing RRR or the Required rate of return. This is significant because it helps understand the return that both the shareholders and the bondholders need to help the company receive the capital it requires. Any company with high stock volatility and risky debts is likely to have a higher WACC.
The weighted Average Cost of Capital and its formula is used by diverse professionals for numerous uses. Investors, company managers, and analysts are the prime users of this. If you are not acquainted with the concept of determining the cost of a firm’s capital, you might want to consider its necessity. There are several reasons for this. One of the prime reasons is the discount price implemented by a firm to help make net value estimations.
Weighted Average Cost of Capital is also significant to map out how useful it can be to acquire the projects of other businesses. Most companies access the market on borrowed funds. This comes from various investors and sources. This is the point where the cost of capital plays a crucial role in evaluating the potential of a firm relating to the net profitability it can make. As a result, during the process of calculation, equity and debt are used as important elements in the WACC formula.
When WACC is low, it is indicative of a well-running business. On the contrary, if the scale for the same is large, it may represent an unhealthy business. Let us delve deeper into the calculation of this structure to understand it better.
We have already mentioned the formula of WACC above. So, let us now talk about the full form of the entire formula.
V stands for E + D
E stands for the Market value of the firm’s equity
D stands for the market value of the debt of the firm
Rd is the cost of debt
Re is the cost of equity
And, Tc is the corporate tax rate
The multiplication of every source that may include both equity and debt by its relevant weight is what helps evaluate the Weighted average cost of capital. So, once the multiplication of what we have mentioned above is done and the products are added together, you will get your answer. In the above formula, we have also observed that D/V is representative of debt-based financing. Similarly, E/C is representative of equity-based financing. As such, the formula summarises two terms-
In this case, the first term is representative of the weighted value of equity capital. On the contrary, the next one represents the weighted value of debt capital.
It is significant to determine the value that each investment opportunity may hold. This is the job of security analysts who can make it possible to determine them. The method can also be implemented by the finance department of a business. With the guidance of this tool, they can help determine the hurdle rates for acquisition or a given project.
RRR, or Required rate of return, is the least rate that is likely to be accepted by an investor for a specific investment. In case they decide to start expecting smaller returns for what they are investing, they will try and scout for other opportunities for better returns. CAPM is one of the methods that analysts execute to determine RRR. In this process, the volatility relative to a much wider market of a stock is used. This helps come up with a clear calculation of the return needed by different stakeholders.
Weighted Average Cost Of Capital is another method that can help estimate RRR.
Weighted Average Cost Of Capital might also be implemented in the field of financial modeling. It is also often known as the hurdle rate utilized by diverse firms in the determination of upcoming projects.