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Corporations create
value for shareholders by earning a
return on the invested capital that is above the cost of that capital.
WACC (Weighted
Average Cost of Capital) is an expression of this cost and is used to
see if certain intended investments or strategies or projects or purchases
are worthwhile to undertake.
WACC is
expressed as a percentage, like interest. So for example if a company works
with a WACC of 12%, than this means that only (and all) investments should
be made that give a return higher than the WACC of 12%.
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.
How
can the Weighted Average Cost of Capital (WACC) be calculated?
The easy part of WACC
is the debt part of it. In most cases it is clear how much a company has to
pay their bankers or bondholders for debt finance. More elusive
however, is the cost of equity finance. Normally, the cost of equity
finance is higher than the cost debt finance, because the cost of equity
involves a risk premium. Calculating this risk premium is one thing
that makes calculating WACC complicated.
Another important
complication is which mix of debt and equity should be used to
maximize shareholder value (This is what "Weighted" means in WACC).
Finally, also the
corporate tax rate is important, because normally interest payments are
tax-deductible.
Formula WACC Calculation
debt / TF (cost of debt)(1-Tax)
+
equity/ TF (cost of equity)
---------------------------------------------------------
WACC
In this formula,
* TF means Total
Financing. Total Financing consists of the sum of the Market values of debt
and equity finance. An issue with TF is whether, and under what
circumstances, it should include current liabilities, such as trade credit.
In valuing a company this is important, because: a) trade credit is used
aggressively by many companies, which in turn affects their business credit, b) there is an interest (or financing)
charge for such use, and c) trade credit can be quite a large sum on the
balance sheet.
* Tax stands for the
Corporate Tax Rate.
Example:
suppose this company:
The Market value of
debt = € 300 million
The Market value of
equity = € 400 million
The Cost of debt = 8%
The Corporate Tax rate
= 35%
The Cost of equity is
18%
The WACC of this
company is:
300:700*8%*(1-35%)
+ 400:700*18%
---------------------------------------------------------
12,5% (WACC - Weighted Average Cost of Capital)
Compare:
IRR | Net Present Value |
DCF
More valuation methodologies
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