Introduction to Weighted Average Cost of Capital

The main objective of this paper is to provide an overview of weighted average cost of capital, that is, how it is computed and interpreted for any company. The weighted average cost of capital is an important aspect for any company to compute and interpret the rate of return that they earn for every dollar that they pay. Introduction to Weighted Average Cost of Capital The weighted average cost of capital is calculated in order to analyze the amount of cost that they will need to pay for the next dollar that the company borrows.

This is an important cost to consider even when considering or deciding between different projects to be undertaken. Every company is financed by either equity or debt. This means that the weighted average cost of capital would consist of all kinds of debt as well as all types of equity. There are two kinds of equity that are common in companies are preferred and common stock which must be weighed separately. The weighted average cost of capital is considered to be an average of the costs of debt and equity according to their proportions so that the company can understand how much of cost is being taken in and by which component.

The weighted average cost of capital shows a clear division of the weight that is allotted to debt and then to equity. “By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances. ” (Investopedia, 2007 ) The weighted average cost of capital, as mentioned above, is also used for evaluating potential projects that can be taken up by the company. However, in order to evaluate the projects, there is a need for a discount rate that is used for finding the net present value of the cash flows that are expected to be received from the project.

The discount rate for the project is then evaluated from the weighted average cost of capital. “A firm’s WACC is the overall required return on the firm as a whole and, as such, it is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. ” (Investopedia, 2007 ) Calculating the Weighted Average Cost of Capital The weighted average cost of capital is simply calculated by the following formula provided:

WACC = wd (1-T) rd + we re Where wd and we are the weights that are allotted to the proportion of debt and equity respectively in the total capital structure of the company, (1-T) is the tax shield component that is saved from the net income of the company by deducting the interest before tax. This means that when interest to be paid on debt is deducted from operating income before tax, this causes the company to have less taxable income and hence, pay fewer taxes to the government.

rd and re are the costs of each debt and equity that are then multiplied with their individual and respective weights in order to give the exact WACC that is required for evaluating the projects and then making an appropriate decision. The reason why WACC is used as a discount factor is because when a new project is taken up, there is new financing that will be required and as mentioned before, the weighted average cost of capital provides a benchmark of the cost of borrowing one more dollar.

The weights of both equity and debt are calculated by using the market values and not the book values of the company. The market value of debt is not easily found and is considered to be the book value of the company at that time. However, there is a difference in the way the market value of equity is calculated. The market value of equity can be calculated by multiplying the price of the company’s share prevailing in the market with the number of shares that are outstanding. This would compute the financing that is received from equity.

The rate of return of both debt and equity can be calculated in a simple manner. For any debt, the rate of return or the cost that will be considered is the interest that is being paid on the outstanding amount. The cost of equity is calculated by the dividend discount model which is as follows: Kr = Dl / Pl + g Another observation that can be made for cost of capital is that “The cost of capital for any investment, whether for an entire company or for a project, is the rate of return capital providers would expect to receive if they would invest their capital elsewhere.

In other words, the cost of capital is an opportunity cost. ” (Value Based Management, 2007 )

References

1. Investopedia. (2007). Weighted Average Cost of Capital (WACC). Retrieved on January 4, 2008 from: http://www. investopedia. com/terms/w/wacc. asp 2. Value Based Management. (2007). WACC – Weighted Average Cost of Capital. Retrieved on January 5, 2008 from: http://www. valuebasedmanagement. net/methods_wacc. html

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