Definition
The Weighted Average Cost of Capital (WACC) is a financial metric that depicts the average rate of return a company is expected to pay its security holders to finance its assets. It is calculated as a weighted sum of the cost of equity and the cost of debt. The weights are proportional to the market values of equity and debt. The formula for calculating WACC is as follows:
\[ \text{WACC} = \left(\frac{E}{V} \times Re\right) + \left(\frac{D}{V} \times Rd \times (1 - Tc)\right) \]
Where:
- \(E\) = Market value of the equity
- \(V\) = Total market value of equity and debt
- \(Re\) = Cost of equity
- \(D\) = Market value of the debt
- \(Rd\) = Cost of debt
- \(Tc\) = Tax rate
Examples
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Example 1: Simple Calculation
- Equity: $500,000
- Debt: $300,000
- Cost of Equity (Re): 8%
- Cost of Debt (Rd): 5%
- Tax Rate (Tc): 30%
\[ \frac{E}{V} = \frac{500,000}{800,000} = 0.625 \] \[ \frac{D}{V} = \frac{300,000}{800,000} = 0.375 \] \[ \text{WACC} = (0.625 \times 0.08) + (0.375 \times 0.05 \times (1 - 0.30)) \] \[ = 0.05 + 0.013125 = 0.063125 = 6.31% \]
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Example 2: Detailed Calculation
- Equity: $1,000,000
- Debt: $500,000
- Cost of Equity (Re): 10%
- Cost of Debt (Rd): 6%
- Tax Rate (Tc): 25%
\[ \frac{E}{V} = \frac{1,000,000}{1,500,000} = 0.6667 \] \[ \frac{D}{V} = \frac{500,000}{1,500,000} = 0.3333 \] \[ \text{WACC} = (0.6667 \times 0.10) + (0.3333 \times 0.06 \times (1 - 0.25)) \] \[ = 0.06667 + 0.015 \approx 0.08167 = 8.167% \]
Frequently Asked Questions (FAQs)
Q1: Why is WACC important for businesses?
A1: WACC is important because it provides businesses with the average cost of financing their operations and expansions. It is used in capital budgeting to evaluate projects or investments.
Q2: How does the tax rate affect the WACC?
A2: The tax rate affects the cost of debt in the WACC calculation since interest expenses are tax-deductible. A higher tax rate reduces the after-tax cost of debt, thereby lowering the WACC.
Q3: Can WACC change over time?
A3: Yes, WACC can change over time due to variations in the cost of debt, cost of equity, changes in the company’s capital structure, or changes in the market value of debt and equity.
Q4: How is the cost of equity determined?
A4: The cost of equity can be determined using models like the Capital Asset Pricing Model (CAPM), Dividend Discount Model (DDM), or by evaluating historical returns.
Q5: Is WACC only applicable to large corporations?
A5: No, WACC is applicable to both large and small businesses. Any company can calculate its WACC to understand its cost of capital and make informed decisions.
Related Terms
- Cost of Equity (Re): The return required by equity investors given the risk of the investment in the company.
- Cost of Debt (Rd): The effective rate that a company pays on its borrowed funds.
- Capital Structure: The particular combination of debt and equity used by a company to finance its overall operations.
- Capital Budgeting: The process of planning and managing a firm’s long-term investments.
- Dividend Discount Model (DDM): A method to value a company’s stock price based on the theory that its present day price is worth the sum of all future dividend payments discounted back to their present value.
Online References
- Investopedia - WACC Overview
- Corporate Finance Institute - WACC
- Wikipedia - Weighted Average Cost of Capital
Suggested Books for Further Reading
- “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen
- “Financial Management: Theory & Practice” by Eugene F. Brigham and Michael C. Ehrhardt
- “Corporate Finance” by Jonathan Berk and Peter DeMarzo
Fundamentals of Weighted Average Cost of Capital (WACC): Finance Basics Quiz
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