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WACC Definition Explained with Formula, Example and Solution

by | Last Updated On March 26, 2023

Weighted Average Cost of Capital (WACC) in finance, why it is important, and how it is calculated.

WACC, or Weighted Average Cost of Capital, is a critical concept in finance that is often used to evaluate the financial viability of a company. It is a calculation of the average cost of capital that a company incurs from both debt and equity sources. In this article, we will discuss what WACC stands for, why it is important, and how it is calculated.

WACC formula

What is WACC?

WACC is a calculation that determines the cost of capital that a company incurs when raising money from both equity and debt sources. The cost of capital refers to the cost of funds used to finance a business. It includes the cost of equity, debt, and preferred shares. WACC takes into account the relative proportion of each of these sources of funding.

Why is WACC important?

WACC is important because it is used to determine the financial viability of a company. It is a key component in determining the discount rate for future cash flows, which is a critical component in any valuation model. If a company has a high WACC, it means that it is more expensive for the company to raise money, which could negatively impact the company’s profitability. On the other hand, if a company has a low WACC, it could be a sign that the company is well-positioned for growth.

How is WACC calculated?

WACC is calculated by taking into account the percentage of each funding source that a company uses and multiplying it by the cost of that funding source. The formula for WACC is:

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

Where:

  • E = Market value of the company’s equity
  • V = Total market value of the company (equity + debt)
  • Re = Cost of equity
  • D = Market value of the company’s debt
  • Rd = Cost of debt
  • Tc = Corporate tax rate

Let’s break down the formula:

The first part of the formula, (E/V * Re), calculates the cost of equity. It takes into account the market value of the company’s equity (E) and divides it by the total market value of the company (E + D) to get the percentage of equity financing (E/V). Then, it multiplies this percentage by the cost of equity (Re).

The second part of the formula, (D/V * Rd * (1 – Tc)), calculates the cost of debt. It takes into account the market value of the company’s debt (D) and divides it by the total market value of the company (E + D) to get the percentage of debt financing (D/V). Then, it multiplies this percentage by the cost of debt (Rd), and subtracts the corporate tax rate (Tc) multiplied by the cost of debt (Rd).

Once you have calculated the cost of equity and cost of debt, you can add them together to get the WACC. The resulting number represents the average cost of capital that a company incurs from both debt and equity sources.

Conclusion

WACC is an important concept in finance that is used to evaluate the financial viability of a company. It is a calculation of the average cost of capital that a company incurs from both debt and equity sources. By taking into account the relative proportion of each of these sources of funding, WACC can be used to determine the discount rate for future cash flows, which is a critical component in any valuation model. Understanding WACC is essential for investors, financial analysts, and anyone interested in evaluating the financial health of a company.

WACC FAQs with Answers

WACC is calculated by multiplying the cost of each type of capital (debt and equity) by its proportion in the company's capital structure and then summing them up. The formula for WACC is: WACC = (E/V x Re) + ((D/V x Rd) x (1 - T)), where E is the market value of equity, D is the market value of debt, V is the total value of the company, Re is the cost of equity, Rd is the cost of debt, and T is the corporate tax rate.

WACC is important in capital budgeting because it represents the minimum return that a company must achieve on its investments to satisfy its investors. If a company's investments do not generate a return that exceeds its WACC, then the company is destroying value for its investors. Therefore, WACC is used as a benchmark rate for evaluating the feasibility of potential investments.

A company can reduce its WACC by lowering the cost of its capital components or changing its capital structure. For example, a company can reduce its cost of debt by refinancing its existing debt at a lower interest rate, or it can issue new debt at a lower interest rate. A company can also lower its cost of equity by improving its credit rating or by increasing its dividend payments, which can attract more investors.

WACC is a useful tool for evaluating investments, but it has some limitations. One limitation is that it assumes that the company's capital structure remains constant, which may not be true in reality. It also assumes that the risk of the company's investments is constant, which may not be accurate if the company's risk profile changes over time. Additionally, WACC may not accurately reflect the cost of capital for specific projects or investments that have different risk profiles than the company's overall operations.

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Nikesh

Nikesh is a Banker and Experienced Financial and Investment Advisor with over 20 Years of Experience in the Field of Finance and Investment. He possesses vast experience in the field of Stock Market, Mutual Funds and Investment Portfolio Management. Keep visiting for daily dose of Share Trading Tips and Tutorials.

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