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Importance and Uses of Weighted Average Cost Capital

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Abstract

A calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation. Here are some major important roles and genral financial uses of WACC.
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Importance and Financial Uses of Weighted Average Cost Capital Page 1
Importance and Financial Uses of Weighted Average Cost Capital
:
Discussion Question:
Suppose you were hired as an Assistant Finance Manager in a leather manufacturing
concern last month. The first task assigned to you was to calculate company’s weighted
average cost of capital (WACC) and provide a detailed report about it to the CEO of the
company. Although you have calculated the WACC after incorporating the required data
but the problem is there in reporting it to the CEO because he doesn’t have enough
financial knowledge. For him, the WACC is just a rate that is used in different financial
affairs of the company whereas you have to make him understand the financial usages of
WACC. You are, therefore, required to identify the different financial usages for which
this particular rate can be used by the company.
A calculation of a firm's cost of capital in which each category of capital is
proportionately weighted. All capital sources - common stock, preferred stock, bonds and
any other long-term debt - are included in a WACC calculation.
Weighted Average Capital Cost:
And its Equation is,
( )
1
ED
WACC R R T
ec
d
VV
= × + × ×−
Where:
R
e
= Cost of equity R
d
= cost of debt
V
= E+D
V
= Market Value of Equity + Market Value of Debit
T
c
= Corporate tax rate
E
V
= percentage of financing that is equity
D
V
= percentage of financing that is debt
WACC=(E/V)x Re + (D/V) x Rd x (1-Tc)
Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
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Importance and Financial Uses of Weighted Average Cost Capital Page 2
D = market value of the firm's debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
It will be conveyed to CEO that this WACC shows us that how much interest the
company has to pay for every dollar it finances.
It will be conveyed to CEO that an increase in WACC notes a decrease in valuation
and a higher risk as the WACC of a firm increases as the debt and rate of return on
equity increases.
It will be conveyed to CEO that WACC will be used to calculate the Net Present
Value (NPV) which will allow the evaluation of projects or investment. As,
NPV=Cost of Project
( )
1
1
ExpectedSaving
n
nWACC
n
+
+
=
NPV=Cost of Project +(Expected Saving/Sum(1+WACC)^n)
The positive NPV means that project under consideration offers advantages and may be
preceded.
The negative NPV means that the financial market offers superior projects in the same
risk class, so the project should be rejected.
The CEO will be briefed that this calculated WACC will also be used as the appropriate
discount rate at which to evaluate the projects. Because the costs of financing (receiving
the loan, making interest payments and repaying principal) are never included as cash
flows when estimating the cash flows to investment, thus cost of financing will be taken
account of in the discount rate.
CEO will be told that using this WACC it can be seen that how much interest, the
company has to pay for every dollar it finances. Also calculated WACC will reflect what
a firm needs to earn on a new investment.
CEO will be told that this calculated WACC shows the value of the firm or its earning’s
potential. Earning potential is maximized if WACC is minimized & vice versa.
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Importance and Financial Uses of Weighted Average Cost Capital Page 3
Ms Lee Lister
The Biz Guru
http://www.StartMyNewBusiness.com
References:
http://www.BusinessPlanNow.com
FINANCIAL ACCOUNTING AND REPORTING 14th Edition By Barry Elliott & Jamie Elliott
Essentials of financial analysis / George T. Friedlob, Lydia L. F. Schleifer.
WACC, Weighted average capital cost, NPV, Net present Value, ACC501 GDB No. 2, MBA
Executive, Importance of WACC, Uses of WACC, Business Finance
Keywords:
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