Weighted Average Cost of Capital (WACC)
What is WACC?
Here is the basic formula to calculate for weighted average:
= ((E/V) * Re) + [((D/V) * Rd)*(1-T)]
A company is typically financed using a combination of debt (bonds) and equity (stocks). Because a company may receive more funding from one source than another, we calculate a weighted average to find out how expensive it is for a company to raise the funds needed to buy buildings, equipment, and inventory.
Let's look at an example:
Assume newly formed Corporation ABC needs to raise $1 million in capital so it can buy office buildings and the equipment needed to conduct its business. The company issues and sells 6,000 shares of stock at $100 each to raise the first $600,000. Because shareholders expect a return of 6% on their investment, the cost of equity is 6%.
Corporation ABC then sells 400 bonds for $1,000 each to raise the other $400,000 in capital. The people who bought those bonds expect a 5% return, so ABC's cost of debt is 5%.
Corporation ABC's total market value is now ($600,000 equity + $400,000 debt) = $1 million and its corporate tax rate is 35%. Now we have all the ingredients to calculate Corporation ABC's weighted average cost of capital (WACC).
x .06) + [(($400,000/$1,000,000) x .05) * (1-0.35))] = 0.049 = 4.9%= (($600,000/$1,000,000)
Corporation ABC's weighted averageis 4.9%.
This means for every $1 Corporation ABC raises from investors, it must pay its investors almost $0.05 in return.
What Does WACC Tell Us?
It's important for a company to know its weighted average l as a way to gauge the expense of funding future projects. The lower a company's , the cheaper it is for a company to fund new projects.
A company looking to lower itsCorporation ABC may issue more bonds instead of stock because it can get the financing more cheaply. Because this would increase the proportion of debt to equity, and because the debt is cheaper than the equity, the company's weighted average would decrease.may decide to increase its use of cheaper financing sources. For instance,
Internal rate of return (IRR) is used to evaluate the attractiveness of a project or investment. If the IRR of a new project exceeds a company’s required rate of return, that project is desirable. If IRR falls below the required rate of return, the project should be rejected.
Used in tandem with the IRR formula, WACC is the "required rate of return" that a project or investment's IRR must exceed to add value to the company. This return rate may also be referred to as a "hurdle rate" or "cost of capital."
For example, if a company's WACC is 10%, a proposed project must have an IRR of 10% or higher to add value to the company. If a proposed project yields an IRR lower than 10%, the company's borrowed money (cost of capital) is costing more than what the proposed project or investment is expected to yield and probably wouldn't yield a positive return to the company.
Here's another way to look at it. If you were to use your credit card with a 10% annual interest rate (think of it like the WACC) to buy a lemonade stand, you'd need the lemonade stand to return 10% or more every year (similar to the IRR) if you wanted to make any money. Otherwise, you'd be losing money every year and not adding value to your net worth!
While IRR makes it easier for managers to decide which project or investment would yield the highest percentage return on investment (ROI), net present value (NPV) measures how much value a potential project or investment could add in absolute dollar amounts.
When considering the WACC, an analyst could apply the percentage WACC to the amount of money needing to be borrowed to complete a proposed project or investment. From there the analyst could compare the NPV against the cost of capital to decide if an investment is worth pursuing.