WACC Calculator

What is the Weighted Average Cost of Capital?

Weighted Average Cost of Capital (WACC) is a financial metric representing the overall cost of capital raised for the company.

A company may be financed using different sources directly by equity from the investors, using debt or emitting bonds. Moreover, each financing round may have additional terms, for example, different interest rates.

That's why metrics such as WACC are crucial for tracking the real cost of raising capital. It is essential for companies using external financing because this value should be lower than the Return on Invested Capital metric. Otherwise, it would mean the company is ineffective in utilizing raised capital to generate profits.

How to calculate WACC?

The WACC formula is derived directly from the weighted average equation.

WACC formula

wacc formula

Where:

E - company's equity value,
D - company's debt value,
V = E + D is the total market value of the company's financial assets
Ce - the cost of equity,
Cd - the cost of debt,
T - the corporate tax rate.

Real-life Example of WACC Calculation

ACME Corp. is a dynamic enterprise that specializes in developing innovative consumer products. As the company envisions a broader market reach and the introduction of new product lines, it's contemplating raising capital. ACME Corp. is presented with two primary financing options:

Issue additional equity shares.
Secure a long-term loan (debt).

To make a reasonable decision, ACME Corp. decides to use the WACC calculator to calculate its WACC for each financing option.

Current Financial Structure:

Equity (E): $5 million
Total Debt (D): $2 million
Cost of Equity (Ce): 8% (calculated using the capital asset pricing model)
After-tax Cost of Debt (Cd): 5% (reflecting the company’s interest payments on the existing total debt)
Corporate Tax Rate (T): 30%

Option 1: Issue Additional Equity: ACME Corp. contemplates issuing equity worth $3 million. Given the dilution and the associated risk, the new cost of equity is estimated at 9%.

Using the WACC calculator to calculate:

WACC = (E / (E + D)) × Ce + (D / (E + D)) × Cd × (1 − T) WACC = (5/10) × 0.09 + (2/10) × 0.05 × (1 - 0.30) WACC = 7.7%

Option 2: Secure a Long-term Loan: ACME Corp. is considering procuring a loan of $3 million at an interest rate of 6%, increasing their total debt.

Using the WACC calculator to calculate:

WACC = (E / (E + D)) × Ce + (D / (E + D)) × Cd × (1 − T) WACC = (5/10) × 0.08 + (5/10) × 0.06 × (1 - 0.30) WACC = 7.1%

Decision:

Wacc example

The results from the WACC calculator indicate that the cost of capital is marginally lower when ACME Corp. opts for a long-term loan compared to issuing additional equity. Thus, from a WACC standpoint, incurring debt appears to be a more cost-efficient source of capital.

However, ACME Corp. will also weigh in other considerations, such as the company's desired capital structure, flexibility in managing its interest payments, and the overarching impact on its financial stability, before finalizing its choice.

This example underscores how enterprises like ACME Corp. can leverage the WACC calculator to evaluate diverse sources of capital and select the one that optimally reduces their cost of capital.

Importance of WACC in Investment Decisions

Using WACC to Influence Investment Decisions: The Weighted Average Cost of Capital (WACC) plays a pivotal role in influencing investment decisions. It serves as a discount rate that a company uses to present the value of its future cash flows. When a project's rate of return exceeds the company’s WACC, it indicates that the project is likely to bring value to the shareholders.

WACC in Capital Budgeting: In capital budgeting, WACC is used as a hurdle rate against which the potential investments are evaluated. If a project's internal rate of return is higher than the WACC, it's considered a viable project. This ensures that the company is effective in utilizing raised capital to generate profits.

Factors Influencing WACC

Market Conditions and WACC: The cost of debt and the cost of equity, two primary components of WACC, can be influenced by prevailing market conditions. For instance, in a rising interest rate environment, the cost of debt might increase, leading to a higher WACC.

Company-specific Factors: A company's capital structure, which is the mix of equity and debt used to finance its assets, can influence its WACC. A company with a higher proportion of debt might have a different WACC than a company that's predominantly equity-financed.

Limitations of WACC

While WACC is a crucial metric in finance, it's not without its limitations:

Accuracy: The WACC calculation relies on several assumptions, including the capital asset pricing model (CAPM) for calculating the cost of equity. Any inaccuracies in these assumptions can lead to a skewed WACC.
Misconceptions: It's a common misconception that a lower WACC is always better. However, a very low WACC might indicate that the company is not taking enough risks, which could stifle growth.

Comparison with Other Metrics

WACC vs. Other Financial Metrics: While WACC gives us an average cost of capital, other metrics like the return on equity or return on assets provide insights into how effectively a company is using its equity or assets.

When to Use WACC: It's essential to use WACC when evaluating investment opportunities or when you need to calculate the WACC as a discount rate for cash flow valuations. For other insights, like a company's operational efficiency, other metrics might be more appropriate.

Advanced WACC Concepts

Marginal WACC

As a company continues to raise more capital, its WACC might change. The cost of the next dollar of capital raised is termed the marginal WACC.

Adjustments for Divisions

In conglomerates with multiple divisions, each division might have its own risk profile and, therefore, its own WACC. Adjusting the company’s WACC for each division ensures that projects are evaluated correctly.

FAQs on WACC

What is the capital asset pricing model (CAPM) in WACC?

CAPM is used to determine the cost of equity. It takes into account the risk-free rate, the company's beta (volatility compared to the market), and the market risk premium.

How does preferred stock influence WACC?

If a company has preferred stock in its capital structure, the cost of preferred stock is included in the WACC calculation, influencing the overall average cost of capital.

Authors

Created by Lucas Krysiak on 2022-06-10 12:56:46 | Last review by Mike Kozminsky on 2022-09-15 14:04:16

The easiest way to calculate the Weighted Average Cost of Capital.