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Weighted Average Cost of Capital

Weighted Average Cost of Capital

What does WACC Mean?

Weighted Average Cost of Capital (WACC) is defined as the weighted average of the cost of various sources of finance, weight being the market value of each source of finance outstanding.

Here cost of various sources means the return expected by the respective investors.

CIMA defines the WACC as “the average cost of company’s finance (equity, debenture, bank loans, etc.) weighted according to the proportion each element bears to the total pool of capital, weightage is usually based on market valuations, current yields and costs after tax.”

Traditionally, optimal capital structure is assumed at a point where WACC is minimum. For project evaluation, this WACC is considered as the minimum rate of return required from the project to pay off the expected return of the investors respectively, and as such WACC is generally referred to as the required rate of return. Accordingly, the relative worth of a project is determined using this required rate of return as the discounting rate.

Simple WACC is calculated without considering the impact of tax on the cost of capital. In the case company is wholly financed by equity the cost of capital will be the cost of equity. Geared companies are the ones which are financed by debt also. In case of geared companies, the WACC can be stated as follows:

WACC = (Cost of equity % of equity) + (Cost of debt % of debt)

WACC can also be calculated after considering tax shields as follows:

WACC = Ke ´ E / (D+E) + (1-T) ´ Kd ´ D / (D+E)

Where Ke is cost of equity capital,

Kd is cost of debt,

E is market value of equity capital,

D is market value of debt,

T is corporate tax rate.

In simple way it can be given as

WACC = (Cost of equity ´ % of equity) + [Cost of debt (1-tax rate) ´  % of debt].

We do the same because we get tax benefit of interest paid on loans. So if we do not consider the tax effect on debt, we will unnecessary be increasing the cost of debt, thereby the weighted average cost of capital.

Let us consider the calculation of WACC with the help of an example.
For example, a firm’s financial data shows the following:

  • Equity = Rs. 800,000
  • Debt = Rs. 200,000
  • Ke = 12.5%
  • Kd = 6%
  • Tax rate = 30%

To find WACC, enter the values into the above equation and solve:

WACC = [{800,000 / (800,000 + 200,000)} * 0.125)] + [{200000 / (800,000 + 200,000)} * 0.06 * (1 – 0.3)]

WACC = 0.1 + .0084 = 0.1084 or 10.84%; the WACC for this firm will be 10.84%.

Weighted Average Cost of Capital

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