What is the Weighted Average Cost of Capital (WACC)?
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
What are the various factors which affect the Weighted Average Cost of Capital (WACC)?
The factors that affect are given as follows:
i. Economic Conditions: The cost of equity of a company generally shows an increase when they are provided with easy loan facilities so as to maintain stability in the organization. As, a result the debt of the company gets reduced significantly. The economic conditions of a country also pay a major role in affecting the cost of a company.
ii. Capital Structure: The Weighted Average Cost of Capital also gets impacted by the debt-to-equity ratio of a company. In case where a firm more debt than the amount of share capital, the cost of stock becomes more and if the debt is less , the equity cost is less. Therefore, the capital structure has a major role in computation of WACC.
iii. Dividend Policy: The dividend policies of a company has a considerable impact on the cost of equity. Whenever a company is in need of a large capital or finances it has a dividend as a tool for raising the necessary finances. The earnings of a company is thereafter paid to the debentures holders of the company in the form of dividends. The policies associated with the payment of dividends has a direct impact on the WACC of the company.
iv. Income-tax rates: The income tax is required to be paid by any business which runs on profit. The tax rates can vary with time due to the change in the legislature or change in the tax bracket within which the company falls. This impacts the WACC on a significant level, the higher taxes mean lower weighted average cost of capital and lower taxes mean higher weighted average cost of capital.
What are the Advantages of WACC?
Following are the advantages of WACC.
- Simple and Easy
The calculation of WACC does not take much time as it is not complicated.
- Single Hurdle Rate for all Projects
The WACC saves much time for the managers in evaluating new projects and if the new project carries the same risk profile as the older project, then in such case, no new WACC is required to be calculated and the current WACC can be applied effectively.
- Prompt Decision making
Under the WACC, since a single rate is used for all the projects, better managerial decisions are taken at a faster rate which eventually benefits the organization and stimulates its growth.
What are the Disadvantages of WACC?
Following are the disadvantages of WACC.
- Difficulty in Acquiring Current Market Cost of Capital
In deriving WACC the present-day cost of capital is required which is very difficult to ascertain. The cost of debt, dividends which are the major components for ascertaining WACC keeps changing with the economy and sentiments of the market.
- Important Sources of Capital avoided
In evaluating WACC only equity, debt, and preference shares are considered with an assumption that they cover a major portion of the capital. However, the short-term borrowings and the cost of trade credit which are also important sources of capital are not taken into consideration because it will make the calculations very complex and will change WACC.
What Are the Components of the Weighted Average Cost of Capital (WACC)?
The components of WACC can be discussed under the following heads.
- Market Value of Debt, which is the market value of debentures plus the loan amount.
- The market value of a share, which is the price of each share ex-dividend × number of shares.
- Cost of debt.
- Cost of equity.
- Company's profit tax rate.
Example: Consider a Company XYZ has an Equity of $500,000, Debt of $500,000, Cost of Debt is 8% and Cost of Equity is 16%. Assuming the tax rate to be 30%, calculate the Weighted Average Cost of Capital (WACC) of the company.
E = $500,000
D = $500,000
rd = 8%
re = 16%
tax rate = 30%,
WACC = [rdebt× (1- tax rate)× Debt ÷ (Debt + Equity)] + [ requity × Equity ÷ (Debt + Equity).
What is the Cost of Equity?
It is the amount of the return which company generally pays to its equity investors. It represents the compensation required by the market in lieu of owning the asset firm and simultaneously also bearing the risk of ownership. It is generally calculated by using two models.
Capital Asset Pricing Model (CAPM)
The capital asset pricing model can be used on any stock and it even does not require any companies to pay dividends. The CAPM is based on the theory that volatility of the stock and the risk factor of the general market is the basis that forms the cost of the stock.
Terms Used in CAPM Model for Calculating Cost of Equity
- Risk-free rate of return: It is the return that is expected out of a risk-free investment.
- Beta: It measures the volatile nature of the asset as compared to the market.
- Expected market return: It is the average rate of return that market gives over a specified period.
Dividend Capitalization Model (DCM)
The dividend capitalization model applies only to those companies which pay dividends by assuming that it will grow at a constant rate. This model of calculating cost of the equity does not take into investment, risk to the extent CAPM does.
Terms Used in DCM Model for Calculating Cost of Equity
- Dividend/ share next year: It is the rate of dividend that has been announced by the company well in advance of its declaration. The information regarding the dividends can be found from the annual report filings of the company and if no information is found, a suitable assumption can be made from historical data.
- Current share price: The share price of a company can be found by searching the company's name on the exchange on which its stocks are being traded.
- Dividend growth rate: It can be ascertained by doing calculations for the company's past growth of the dividends and taking out the average for the same.
While computing WACC it is to be taken care that tax rates are populated properly and in computation the book value of the debt and equity is to be taken instead of actual value. The cost of debt is usually the after-tax cost of debt which is put into the equation.
- Calculation of Weighted Average Cost of Capital (WACC)
WACC = [rdebt× (1- tax rate) × Debt ÷ (Debt + Equity)] + [ requity × Equity ÷ (Debt + Equity).
Debt = market value of debt
Equity = market value of equity
rdebt = cost of debt
requity = cost of equity.
- Cost of equity using a capital asset pricing model
Cost of equity= Risk-free rate of return + Beta × (Market rate of return - Risk-free rate of return)
- Cost of equity using DCM model
Cost of equity (Re) = (D1 ÷ P0) + g
D1 = Dividend /share next year
P0 = Current share price g = Dividend growth rate
Context and Applications
The WACC serves as the discount rate for determining the net present value of the business and it is used as a discount rate while budgeting for a new project. The WACC is also used for evaluating investment opportunities because it said to represent the opportunity cost of the firm and is used a hurdle rate by the companies for considering mergers and acquisitions.
This topic is significant in the professional exams for both undergraduate and post-graduate courses, especially for:
- B.com (Honors) (Bachelor of Commerce)
- M.com (Master of Commerce)
- Chartered Accountants (CA)
- Company Secretary (CS)
- MBA (Finance)
- Internal Rate of Return.
- Capital structure.
- Return on Invested Capital.
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