What Is Weighted average cost of capital?

The combined cost of capital of a firm is represented by weighted average cost of capital. Cost of capital of any firm is the necessary income which must be generated to case the cost of capital used in multiple operations. Cost of debt and cost of equity are both covered by the cost of capital of a firm.

Weighted average cost of capital includes all roots, namely common shares, preferred shares and debt. The value of each category of the capital is weighted by the total percentage it holds against the complete capital and then are added all together.

What is WACC Formula?

By using WACC formula you can calculate the weighted average cost of capital. 

Wacc formula

Where

  • E= Firm’s Total Equity
  • V= Market Value Of the company/ Firm (Equity+Debt)
  • D= Total Debt of the Company/ Firm
  • Re= Total Cost of Equity
  • Rd= Total Cost Of Debt
  • Tc=  Corporate Tax rate

Calculation Of WACC

Weighted average cost of capital (WACC) can be calculated by dividing the Firm’s Total equity by the total market value of the company (E+D) multiplied by the cost of equity multiplied by the Total debt of the company by the total market value of the company’s equity and debt multiplied by the cost of debt times 1 minus the corporate tax rate.

Importance of Weighted Average Cost of Capital

Here are the points mentioned explaining the importance and uses of weighted average cost of capital of a business.

Investment Decisions:

Making investment decisions of a business requires its weighted average cost of capital (WACC) in terms of project evaluation.

  • Project evaluation with similar risk- Whenever a firm thinks of evaluating new projects, it is necessary to figure out the risk factors. In case the risk factors in existing projects of the company are much similar to that of the newer projects then WACC plays an essential role in confirming whether those projects should be accepted or rejected.

        Example- If a garment manufacturer plans to inaugurate a branch of similar project at any other location then the manufacturer can easily go through his WACC for taking the decision. WACC of the same project can reflect whether the secondary branch would be profitable or not.

  • Project evaluation with different risk- WACC is a suitable estimate which can be used in evaluating any project which includes two assumptions. Same risk and the same capital structure are the assumptions. Concepts like risk adjusted weighted average cost of capital and adjusted present value are used to avoid WACC assumption issues.

Calculates Economic Value Added (EVA):

Weighted average cost of capital is the major need in calculating economic value added of a business. EVA is determined by withdrawing cost of capital from the profit earned by the unit. WACC is taken as the cost of capital in figuring the EVA.

Weighted average cost of capital of a business reflects the least rate at which the company should earn to meet the expectations of the financial investors.

Valuation of the Company:

It is practically acceptable that any of the investor will take time before investing money in a business. The investor proceeds for getting the valuation of the company. The valuation of a company can be done when the investor figures the future cash flows in a business and minimizes them using its weighted average cost of capital (WACC).

The value of debt is eliminated from the value of company to get the value of equity. The value of equity is then divided by the number of equity shares. This figure outs the per-share value of the company. The investor then compares the per-share value with the current market price (CMP) to judge whether the business is worth investing or not.

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