WACC Video Notes

Introduction to Weighted Average Cost of Capital (WACC)

• The term "Weighted Average Cost of Capital" is commonly abbreviated as WACC.

• WACC represents the average rate that a firm is expected to pay to finance its assets, weighted by the proportion of debt and equity in its capital structure.

Concept of WACC

• WACC is crucial in financial decision making, helping firms understand the cost of financing their operations.

• It is derived from two primary sources of financing:

  • Debt: funds obtained through borrowing.

  • Equity: funds raised through shareholders’ investments.

Components of WACC Calculation

Debt and Equity Financing

• When calculating WACC, it is essential to understand both the total debt and total equity used for financing.

• The debt might constitute a small portion, e.g., 10%, while equity might constitute the remainder (e.g., 90%). This proportion is critical in calculating WACC.

Formula for WACC

• WACC is expressed by the following formula: $ext{WACC} = rac{E}{V} imes r<em>e + rac{D}{V} imes r</em>d imes (1 - T)$ Where:

  • E = Market value of the firm's equity

  • D = Market value of the firm's debt

  • V = Total value of financing (E + D)

  • $r_e$ = Cost of equity

  • $r_d$ = Cost of debt

  • $T$ = Tax rate

Cost of Equity

• The cost of equity ($r_e$) is the return required by equity investors, which can vary depending on the firm's risk profile.

• For example, a firm may have a cost of equity of 8%, 9%, or 15%, depending on market conditions and the company's risk.

Cost of Debt

• The cost of debt ($r_d$) represents the effective rate that the company pays on its borrowed funds.

• It is often measured using the yield to maturity (YTM) on existing debt, for instance, it might be 6%.

• The cost of debt should be adjusted for taxes because interest expenses are tax-deductible.

Why Tax Adjustment is Necessary

• The formula for WACC factors in a tax shield on debt, hence the expression $r_d imes (1 - T)$ is used.

• This adjustment reflects the reduced effective cost of debt after tax considerations.

Example Calculation of WACC

Scenario Setup

• Assume:

  • A firm borrows $2,000 at an interest rate of 6%.

  • The firm raises $8,000 in equity.

  • The tax rate is 40%.

  • The cost of equity ($r_e$) is assumed to be 12.5%.

Steps for Calculation

1. Determine Total Financing:

   • Total Debt (D) = $2,000

   • Total Equity (E) = $8,000

   • Total Value (V) = D + E = $2,000 + $8,000 = $10,000

2. Calculate Proportions:

   • Proportion of equity: $rac{E}{V} = rac{8,000}{10,000} = 0.8$ or 80%.

   • Proportion of debt: $rac{D}{V} = rac{2,000}{10,000} = 0.2$ or 20%.

3. Incorporate Costs into WACC Formula:

   • Contribution from equity: $0.8 imes 0.125 = 0.1$

   • Contribution from debt (after tax): $0.2 imes 0.06 imes (1 - 0.4) = 0.2 imes 0.06 imes 0.6 = 0.0072$

4. Calculate Total WACC:

   • By adding both contributions:

   • WACC = 0.1 + 0.0072 = 0.1072

   • As a percentage: 10.72%.

Importance of WACC in Decision Making

• WACC provides a benchmark for evaluating new projects.

• If a firm's expected return on an investment exceeds its WACC, it may create value for shareholders. Conversely, returns below WACC could diminish value.

Conclusion

• WACC emphasizes the distinct weights of debt and equity when calculating the overall cost of capital.

• Merely averaging costs without consideration of their respective weights leads to an inaccurate representation of the firm's financial situation.

Final Note

• Understanding and calculating WACC is fundamental for finance professionals as it plays a critical role in investment appraisal and corporate financial strategy.