The weighted average cost of capital (WACC) is a specific calculation, in which we estimate the proportional capital cost to companies and organizations wanting an assessment of their different capital infusion. Let’s assume a company A takes loans on the circulated corporate bonds or shares which incurs through different capital sources. In such positions, the amount and percentage of capital differ and require a precise calculation method, i.e., the weighted average cost of capital.
Understanding The Weighted Average Cost Of Capital
Key attributes of the weighted average cost of capital
Many accountants, shareholders, business analysts, financial managers, and others use the weighted average cost of capital as a useful financial tool. By using the numbers which represent the time in the WACC equation or metric, one can easily get the financial positioning. Variations of the interest rates, market situations, and price to earnings ratios may not be present in the WACC calculations. Following are the distinct characteristics of the WACC calculation:
- Serves as a suitable means to determine the capital leveraging cost.
- Assists financial analysts and others to streamline the corporate budgets.
- It always aids strategic planners, shareholders, and others to determine the financial positioning.
- Serves as a medium to compare cost competitiveness.
- Assists to define the capital component’s percentage cost.
- Assists to determine the Discounted Cash Flow (DCF).
How to measure the weighted average cost of capital
In the process of measuring WACC, one first requires to determine each component’s cost, the dollar amount, and the capital percentage proportion of all forms. For instance, Company A may have various forms of capital with different price structures like the capital allocation of 25% in Corporate bonds, 40% in common stock, 10% in preferred stock, and 25% in business loans. Here the interest for corporate bonds may cost 6%, 12% return, including dividends for the common stock, 14% for the preferred stock, and 5% for the business loans.
These percentage costs result in the following WACC equation:
Step 1: Cost of Equity: A cost of equity calculation may determine the cost if circulated shares are a component cost of WACC. By using some ways, we can determine the cost of equity, two of which include:
- The capital asset pricing model
- Dividing dividends plus expected return by the market price
- Expected shareholder return.
The cost of equity can cover investment bank charges and costs linked with the issue if they share new issues.
EX: If the shareholders of entity A expect a return of $1.10 on an $11.00 stock, then the cost of equity will be $1.10/$11.00=10%. If A also issues dividends, then there will be an addition of dividend cost and expected shareholder return, i.e., a .20 cent annual dividend + $1.10=$1.30/$11.00=11.8%
Step 2: WACC=%Weight of component 1 (1-T) + % weight of component 2 (component 2)+ % weight of component 3(component 3)+% weight of component 4 (1-T) where T= 10% tax cost reduction or 90% of bond and loan debt.
Advantages and disadvantages of WACC
The significance of the cost of equity value is present in the weighted average cost of capital. Generally, the market cost of equity is not static, and the actual cost of capital fluctuates. The fluctuation in the cost of capital depends upon the investor’s expectations, and thus it may not be an accurate figure. However, the WACC calculation helps to determine a clear assessment if not a precise cost of capital leveraging. Usually, low WACC % is more beneficial for the company. This calculation method also assists in comparing a cost benchmark. But sometimes, the values in the WACC equation can be misleading.
For instance, if entity A pays off a loan using retained earnings by assuming that the WACC is too high. Then the loan portion of the WACC calculation will decline to assume no other loans are there. As the remaining capital may be in higher-cost equity leveraging, this could result in more cost of capital. Thus, WACC is a calculation of capital distribution and the cost linked with the distribution of funding and not an operating cost. If the market, economic conditions, and corporate performance are positive, the company’s valuation may increase, which can cause variations in the WACC if shareholders’ expectations do not adjust.
The changes in the interest rate of Variable loan debt may also cause a variation in the WACC. To interpret the result of the WACC calculation, you must be aware of the terms & conditions, context, and environment of capital costs.
In Brief, WACC is a metric that assists in quantifying percentage distribution of cost for many non-equal sources of capital. It provides businesses with a quantitative value to evaluate financial decisions, ensure adequate cash-flow, and make debt management choices. A tax deduction for the after-tax cost of capital helps to calculate the WACC and may comprise a cost of the equity component. There are various ways to complete this method.
Recommended: Use Of Normal Distribution In Finance
A WACC calculation may have a short expiration in terms of accurately representing the capital costs due to the above reasons and variations in cost conditions. It helps to determine and understand the financial status of any business and what that capital costs. The WACC calculation serves as a financial indicator and helps to get a more precise knowledge of the corporate capital structure.