When running a business, you are likely to require borrowed funds at some point. This is why calculations on the cost of capital are so usual to business planning and growth. The weighted average cost of capital (WACC) is a metric used by investors to measure whether a company is worth investing in. We've compiled this short guide to the weighted average cost of capital and how to calculate it.
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WACC - explained
WACC refers to a calculation of a company's blended cost of capital. The calculation consists of weighing each type of capital by its percentage of the total amount of capital. You then add these together. All sources of capital need to be included, ranging from bonds, common stock, and long-term debt to capital. The WACC can be used by investors as a minimum rate of return expected from an investment. It informs decisions on investment opportunities and can also be used as the discount rate in net present value calculations.
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Calculating the weighted average cost of capital
The formula for calculating the WACC is as follows: WACC = (E/V x Re) + ((D/V x Rd) x (1-T)).
"E" is the total market value of the company's equity, "V" is the total value of capital, "Re" the cost of equity, "D" the market value of the company's debt, "Rd" the cost of debt and "T" the rax rate. Every component of the total capital is multiplied by its proportional rate. This is subsequently multiplied by your company's corporate tax rate.
The cost of equity is crucial to the correct implementation of the WACC formula. To identify the cost of equity, you need to look at how investors buy and sell stocks. To keep shareholders interested in keeping their shares of your business rather than selling it, you need to deliver a certain return on their investment. The cost of equity then is the amount you need to spend to maintain a good enough share price.
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Advantages and disadvantages of calculating your business's WACC
There is several benefits to WACC calculations. They are frequently used to decide whether to invest in a company or not. A high weighted percentage can indicate a business's cost of financing is high. This could mean that the company's capital structure will not allow for additional expenses, such as the repayment of a loan or debt. The business would be less likely to produce value, and may not be a good investment.
However, it can be challenging to learn how to do a WACC calculation. Some parts of the equation are inconsistent and may be recorded in different ways across different businesses. This means WACC rates can be hard to compare with those of other companies.