Summary of Weighted Average Cost of Capital (WACC)

Weighted Average Cost of Capital (WACC)

  • WACC is a method to calculate a company's cost of capital, considering debt, preferred shares, and equity.

  • Key components:

    • Cost of Debt

    • Cost of Preferred Shares (if applicable)

    • Cost of Equity

Calculation of WACC

  • Example:

    • Company XYZ raises $100,000 by issuing $30,000 in bonds (debt) and $70,000 in equity.

    • Debt portion = rac30,000100,000=30%rac{30,000}{100,000} = 30\%; Equity portion = rac70,000100,000=70%rac{70,000}{100,000} = 70\%.

  • Cost of Debt = 4% (interest rate on bonds).

  • Cost of Equity = 10% (higher due to investor risk).

  • WACC formula components include:

    • Weight of Debt (Wd) = 30%

    • Cost of Debt (Rd) = 4%

    • Weight of Equity (We) = 70%

    • Cost of Equity (Re) = 10%

Tax Rate Adjustment

  • Tax adjustment for debt:

    • If tax rate (t) = 25%, 1−t=0.751 - t = 0.75; adjusted cost of debt = 4%×0.75=3%4\% \times 0.75 = 3\%.

  • After tax, WACC formula indicates minimum return needed for investments.

Decision Based on WACC

  • Company's project returns vs. WACC:

    • If project return < WACC, do not invest (loss of wealth).

    • If project return > WACC, invest (create wealth).

Applications of WACC

  • Use WACC in discounted cash flow (DCF) valuation techniques.

  • Example: Expected cash flows of $1,000,000 in 2 years, discounted using WACC of 7.9% leads to present value of $858,929.

  • Per share valuation if 10,000 shares outstanding:

    • rac858,92910,000=85.89rac{858,929}{10,000} = 85.89 per share.

    • Compare with current trading price to assess valuation (under/over valued).

Conclusion

  • Understanding WACC is crucial for making informed investment decisions.