The key to running a successful business is to know the cost of running it and ensure that the returns are higher than the cost. However, it is equally important to understand the true cost of finances needed to run the business. This is where WACC comes into the picture and it provides correct information on the actual cost of capital employed in the business. Given hereunder is the meaning of WACC and related details of the same.
Read More: How to read financial statements of a company?
What is WACC?
WACC stands for Weighted Average Cost of Capital and is a calculation that represents a company’s average cost of raising capital. It is a measure of the average cost/interest rate that a company must pay to finance its operations and investments.
The WACC is calculated by considering different sources of capital including debt, equity, and preferred stock, and assigning a suitable weight to each. These weights are based on the amount of capital raised from each of the sources of capital. The WACC is used to determine the minimum rate of return that a company must earn to satisfy its stakeholders and is commonly used in capital budgeting and investment analysis.
What is the formula to calculate WACC?
The formula to calculate WACC is:
WACC = (E/V) * Re + (D/V) * Rd * (1 – Tc)
Where:
E = Market value of the company’s equity
V = Market value of the company’s debt and equity (E + D)
Re = Cost of equity [estimated using the Capital Asset Pricing Model (CAPM)]
D = Market value of the company’s debt
Rd = Cost of debt (estimated as the yield on the company’s debt)
Tc = Corporate tax rate
The weights (E/V and D/V) reflect the proportion of each financing source in the company’s capital structure, and the cost of each source (Re and Rd) is multiplied by its weight to arrive at the WACC.
What is a WACC calculator?
A WACC calculator is a tool that allows you to calculate a company’s Weighted Average Cost of Capital (WACC) in a faster and more efficient manner. The calculator typically requires an input of various financial data. This data includes,
- The market value of the company’s debt
- The market value of the company’s equity
- Cost of equity
- Cost of debt
- Corporate tax rate.
Based on this information, the calculator then performs the WACC calculation and provides the result.
WACC calculators are widely available online and are commonly used by financial analysts, investors, and businesses to estimate the cost of capital for a company. The WACC is a key factor in many financial decisions, such as investment analysis and capital budgeting, and a WACC calculator can be a useful tool in these contexts.
What are the pros and cons of using WACC?
There are various pros and cons of using WACC as a metric of financial analysis and decision-making process. The details of the same are given below.
Pros
The pros of using WACC are highlighted below.
- Reflects the cost of all sources of financing
WACC takes into account the cost of all sources of financing, including debt, equity, and preferred stock, and weights them according to their relative importance in the company’s capital structure. This provides a more comprehensive picture of a company’s cost of capital than relying on the cost of just one source of financing.
- Considers the risk associated with each source of financing
WACC takes into account the risk associated with each source of financing and assigns a weight accordingly. This allows for a more accurate representation of a company’s cost of capital and helps to ensure that investment decisions are based on a realistic assessment of the cost of capital.
- Simple and easy to calculate
The WACC calculation is relatively straightforward and can be done with readily available financial data. This makes it a widely used and accessible metric for financial analysis.
- Helps in investment and capital budgeting decisions
WACC is often used as a minimum rate of return requirement in investment and capital budgeting decisions. By knowing the cost of capital, companies can make informed decisions about which investments to pursue and which ones to avoid.
Overall, WACC provides a useful and comprehensive measure of a company’s cost of capital, which is a key factor in many financial decisions.
Cons
While WACC has many benefits as a metric for financial analysis, there are also some limitations and drawbacks to using it:
- Ignores financing mix changes over time
WACC assumes that the proportion of debt and equity in a company’s capital structure remains constant over time, but this is rarely the case in practice. Changes in the financing mix can have a significant impact on a company’s cost of capital and the accuracy of WACC as a metric.
- Does not account for all sources of financing
WACC only takes into account the cost of debt, equity, and preferred stock, but there may be other sources of financing that are not included in the calculation. This can result in an incomplete representation of a company’s cost of capital.
- Subject to estimation error
WACC is based on estimated values for the cost of equity, cost of debt, and the tax rate, which can introduce errors in the calculation. This can result in an inaccurate representation of a company’s cost of capital.
Overall, while WACC provides a useful measure of a company’s cost of capital, it is important to understand its limitations and be aware of potential errors in the calculation.
Conclusion
WACC is an important measure in understanding the cost of a business. A business with a higher WACC is usually considered to be a riskier business while a business with a lower WACC is considered to be a healthy business that can usually attract investors more easily. Therefore, it is one of the most crucial parameters reviewed by investors and lenders to ascertain the viability of their funds in the business.
FAQs
No. WACC is used to provide the true cost of capital for a company but it cannot be used as a sole indicator of evaluating a company. The other indicators that can be used for this purpose along with WACC are revenue and earnings growth, competitive position, debt and liquidity levels, and management effectiveness, among others
CAPM (Capital Asset Pricing Model) is a financial theory model that describes the relationship between risk and expected return for investments. The model helps investors calculate the cost of equity of a company or the expected return on an investment based on its systematic, or market, risk.
WACC considers preference share capital along with debt and equity to calculate the true cost of capital for the company as a whole.
After calculating a company’s WACC, it is compared against the industry average or that of its closest peers to understand if the company has a higher WACC or lower. Typically, a company having a higher WACC means it requires a higher cost of financing and will have fewer funds at its disposal for its shareholders and to meet other expenses.
