When a company uses finance from its capital structure in different activities, it must know the costs associated with finance. While calculating the cost for a single type of finance may be straightforward, practically, companies don’t use a single type of finance for each operation. They use a mixture of equity and debt finance to achieve their objectives. Therefore, they must calculate the overall cost of finance for a specific project or operation complex. To calculate the cost, a company can use a calculation known as the Weighted Average Cost of Capital.
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What is WACC?
The weighted average cost of capital is defined as the weighted average of a firm’s cost of capital for its capital structure. The Weighted Average Cost of Capital (WACC) represents the cost of capital of a company based on its mixed capital structure. In other words, it denotes the average cost of the capital structure of a company. WACC incorporates the cost of all types of finance, such as ordinary shares, preferred shares, debt instruments, etc. in order to calculate the cost of capital of an entity. The main reason why companies calculate WACC is to obtain a cost of capital, which is necessary for their decision-making process.
When it comes to capital structure, there are two different views, which also affect the WACC of a company. These views include the traditional view and the net operating income view.
The traditional view of WACC
The traditional view for capital structure says that when a company minimizes its WACC, it can maximize its returns. It states that the company can utilize a mix of both equity and debt instruments to achieve an optimal structure of capital. According to the theory, the optimal point is when the marginal cost of equity and the marginal cost of debt equalize. If these are not equal, the company still has room to change its capital structure and achieve an optimal cost of capital.
According to the traditional view, a company does not maximize its income by investing in projects that bring a positive return. Instead, the company must also focus on the blend of capital structure it uses to finance the projects. This way, the company can ensure that it creates maximum value while keeping the cost of capital at a minimum.
The Net Operating Income view of WACC
The Net Operating Income view of capital structure states that the value of a company does not alter with a change in the debt component of its capital structure. According to the theory, any return that a company gets from including debt in its capital structure is net off by the simultaneous increase in the required rate of return demanded by its shareholders. In other words, the view suggests that while debt decreases the cost of capital of a company, the cost of equity increases it. Therefore, the effects cancel out each other.
The Net Operating Income view is based on some assumptions. First of all, it assumes the overall capitalization rate remains constant regardless of the capital structure mix of the company. Similarly, it also assumes that the WACC of a company will not change, even if there is a change in its capital structure. It is because, as the view suggests, the decrease in WACC due to debt is net off by an increase in the cost of equity. Lastly, it assumes the value of equity of a company is the difference between its total value less the value of its debt.
What is it used for?
WACC has many different uses for companies. First of all, companies use the WACC for capital budgeting and decision-making purposes. Capital budgeting consists of making decisions about various projects. It is one of the most crucial parts of the investment appraisal process of a business. Without the WACC, there are some techniques such as the Net Present Value (NPV), the Internal Rate of Return, the Discounted Payback Period techniques, which would not be possible. Through these processes, a company can maximize its returns.
The WACC is also vital for companies when making decisions regarding their capital structure. It can further help companies maximize their profits by finding an optimal capital structure that works according to their requirements. Furthermore, it can also be beneficial when it comes to the budgeting process of a company.
How to Calculate Weighted Average Cost of Capital (WACC)?
To calculate WACC, a company must first calculate the cost of each type of finance, usually only equity and debt, it has. Once the cost of each type of finance is known, the company can weigh it according to its value and add them to get a WACC. To calculate WACC, companies can use the following formula.
WACC = [(E / V) x Ke] + [(D / V) x Kd x (1 – T)]
Each of the following factors affects the weighted average cost of capital, and here’s what they represent:
E = Market value of the equity of a company
D = Market value of the debt of a company
V = E + V
Ke = Cost of equity
Kd = Cost of debt
T = Tax rate
Example and Calculation
A company, ABC Co., has a cost of equity of 12% and a cost of debt of 7%. The market value of its equity is $10 million and of its debt is $5 million. The total market value of its equity and debt, or its capital structure, is $15 million. The percentage of corporation tax that it pays is 20%. To calculate its WACC, ABC Co. must use the following formula.
WACC = [(E / V) x Ke] + [(D / V) x Kd x (1 – T)]
Based on the above formula, we get:
WACC = [($10 million / $15 million) x 12%] + [($5 million / $15 million) x 7% x (1 – 20%)]
WACC = [0.67 x 12%] + [0.33 x 7% x 0.8]
Hence, WACC = 8.5%
How WACC is calculated under the Marginal Cost of Capital Approach?
Under the Marginal Cost of Capital approach, a company can calculate its cost of capital for a single additional dollar raise in its capital. It denotes the cost of raising any additional capital, which can help the company evaluate different sources of finance with each other. Calculating the marginal cost of capital is necessary when making decisions regarding the capital structure of the company. However, it cannot use the marginal cost of capital in the same way as the weight average cost of capital.
To calculate the Weighted Marginal Cost of Capital, a company can use the following formula.
Weighted Marginal Cost of Capital = (Proportion of capital1 x After-tax cost of capital1) + (Proportion of capital2 x After-tax cost of capital2) + … + (Proportion of capitaln x After-tax cost of capitaln)
Arguments against using the WACC
There are some arguments that experts make against using WACC. First of all, through the tax shield, the WACC formula can cover companies that use a significant amount of leverage. It means the WACC of companies with substantial debt is lower because of it. It can encourage companies to increase their debt to achieve a favourable WACC. Secondly, the WACC, through the cost of equity, may also incorporate the risks of a company. However, the risk is just a measure of volatility and not a measure of real risk.
The WACC can also have some limitations. Firstly, to calculate WACC, companies need several other calculations, such as the cost of equity and cost of debt. For some smaller companies, calculating those amounts may not be possible due to the lack of information. Similarly, WACC uses certain assumptions, which can be hard to ascertain. For example, the WACC assumes a uniform capital structure, which may not be possible. It also assumes the risk of a new project is the same as the risk of the company. Once a company calculates the cost of capital, it may also be difficult for it to obtain new finance with the same cost, which can affect its WACC.
Companies obtain finance from different sources, which may come with their costs. They need to understand the cost of finance to make better decisions. Therefore, companies must calculate a weighted average cost of capital. The weighted average cost of capital is defined as the weighted average of a firm’s total capital structure. Companies can also calculate the cost of capital for additional finance, known as the marginal cost of capital. There are several arguments against the use of WACC. Similarly, it may have some limitations as well.