WACC - Weighted Average Cost of Capital
What is the WACC?
The WACC or Weighted Average Cost of Capital is basically what it says it
is. It's an average of the cost of financing the company, for example most
companies will have some form of debt (interest),
and equity (required
return), so to acknowledge the cost of this financing the company needs to
calculate the average - weighted by % e.g. 70% debt, 30% equity, in order to
make effective investment decisions. The reason it is important in making
investment decisions is that it represents the cost of capital or the cost of
financing - so any project must earn a return equivalent to at least the WACC in
order to create value and justify the use of the capital.
How does it relate to Markets?
The WACC is used in discounted cash flow models to value a company. This
consists of forecasting the firm's future cashflows and summing the net present
value (present value of expected future cash flows + a terminal value). It is
important to value a company when investing based on fundamentals or a value
based strategy. It is also interesting to note that many broker research reports
arrive at their stock price valuations using a discounted cash flow model - with
the WACC being a key input. The WACC will differ depending on the use of debt,
availability of tax shields, and risk level assigned to the company's stock.
Calculation
The formula is reasonably simple at its basic level. It is simply the
weight or proportion times the cost e.g. if equity costs 15% and finances 50% of
the company's assets then the weighted cost of equity capital would be 7.5%, and
if the interest rate on that same company has an after tax cost of 5%, then with
a 50% weighting the debt component would be 2.5%, therefore the weighted average
cost of capital for this company would be 10%. The formula below (source)
sets this out more formally. Of course, the more complex a company's capital
structure, the more complex WACC analysis will be. But overall it is a
relatively simple process, you will find the most difficult aspects are doing
the groundwork behind it to calculate the individual cost of each capital
component, e.g. running the CAPM to find the cost of equity capital.
Origins
Much of the theory and thinking behind the WACC in the field of
finance/financial economics comes from the Modigliani-Miller theorem; which you
should study up further if a finer knowledge of the issues and insights around
WACC is required:
Modigliani, F.; Miller, M. (1963). "Corporate income taxes and the cost of capital: a correction". American Economic Review 53 (3): 433–443.
Sources and further reading:
Value Based
Management - WACC
Investopedia - WACC
Application of WACC
Calculate WACC on US stocks
Graph Library:
n/a
Original Source:
http://www.econgrapher.com/encyclopedia-WACC.html
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