What is WACC?

WACC means Weighted Average Cost of Capital. The average rate that a company pays to finance its assets. Understanding WACC and its benefits gives a clear idea about how decisions are made inside the company.

About WACC

WACC is the average rate calculated by equally averaging the cost of equity and debt from all sources. It is also known as the marginal cost of capital or the firm's cost of capital. In simple words, if a company is investing in highly volatile stocks, then the WACC value will be higher. It helps in determining the RRR (required rate of return).

WACC Calculation

Even before understanding the WACC calculation, it's important to know the terms that help in the calculation of WACC. We have to consider the following factors :

1. Market Value of Equity: The market value of equity is the total value of the company. It is calculated by multiplying the latest share price and total shares outstanding.

MVE = Market Share Price * Total outstanding shares.

2. Total Market Value: The total market value is the value of outstanding shares in shares in the market.

3. Market Value of Debt: The market value of debt represents the company’s financial position. When the investor buys a company's debt then it is known as the market value of debt.

4. Required Rate for Equity: It's the hurdle rate that an investor expects after investing in a company or stock.

5. Tax rate on the corporation: The tax rate on the company’s annual income is the tax rate on the corporation.

6. Cost of Debt: When a company pays interest rate on the funds which are borrowed from the investor then it's the cost of debt.

WACC Formula

The weighted average cost of capital is easy to calculate. Its calculation is done by using the given formula :

WACC = (E/V * Re) + (D/V * Rd * (1 - Tc)) )

E: E means “market value of Equity”
V: V is “Total Market Value”
Re: Re means “Required Rate of return for Equity”
D: D is “market value of Debt”
Rd: Rd stands for “Cost of Debt”
Tc: Tc means “Tax rate on a corporation”

Importance of WACC

WACC is important because of various reasons. But the main reason is it helps in analysing the performance of the company. The valuation of companies is done by using the WACC. The analysts analyse the financial status of the company by using models like discounted cash flow.

Also while deciding the budget for the company the financial analysts use the weighted average cost of capital.

Example

To understand the WACC calculation let's take an example :

Let's take “ABC” as the company. So ABC makes water bottles to sell. ABC’s market value of debt is Rs. 40 crore and the market value of equity is Rs. 80 crore. Also, the corporate tax is 0.5%, the cost of equity is 10% and the cost of debt is 4%.

Therefore,

total capital value = market value of debt + market value of equity

= Rs 40 crore + Rs 80 crore

Total capital value = Rs 120 crore.

Now calculating WACC

The value of E = Rs 40 crore , V = Rs 120 crore , D = Rs. 80 crore

Re = 10% , Rd = 4% , Tc = 0.5%

E/V = Rs 40 crore / Rs 120 crore = 0.33

D/V = Rs 80 crore / Rs 120 crore = 0.66

WACC = (0.33 * 10%) + ((0.66 * 4%) (1 - 0.5%))
= 3.3% + 2.64%* 0.5%
= 4.62%

Understanding Cost of Capital

The cost of capital is the minimum profit that a company has to generate to run its operations successfully. Its calculation is done so that the investors can know how much returns they will get. From the investor's perspective, it's very important to have some returns on the investments.

Here the funds are given to the company by the investor. In return, the company has to show the investor how much returns they are gonna get after investing in them. So the company has to calculate the cost of capital. The cost of capital tells about the minimum returns that the company will generate.

It helps in financial risk assessment and helps the company to make healthy financial decisions.

Also, Check - SIP Calculator

WACC Benefits

Weighted Average Cost of Capital compares the cost of equity and debt.
WACC value acts as an indicator if high then the business is riskier and if low business is healthier.
Helps the investors in making strategic finance decisions to make a profit.
A hurdle rate helps in evaluating internal investments.

Conclusion

As the company grows the revenue starts generating. From the business point of view, it's very important to know the WACC. And it becomes necessary for the company to evaluate the company’s performance from time to time. Here WACC helps the company in assessing the growth. WACC value allows the company managers or directors to make sound decisions about the company.