Importance and Use of Weighted Average Cost of Capital (WACC)

A company is raising funds from different sources of finance and doing business with those funds. The company has a responsibility to give a return to its funding providers. If a company has only one source of financing, then it is the rate at which it is required to earn from the business. However, the company may have raised funds from more than one source of finance, in which case WACC (Weighted Average Cost of Capital) must be found, which indicates the minimum rate at which the company should earn from the business in order to give a return to its finance providers, as per their expectations. The importance and usefulness of the weighted average cost of capital (WACC) as a financial tool for both investors and companies are well accepted among financial analysts. It’s important for companies to make their investment decisions and evaluate projects with similar and dissimilar risks. The calculation of important metrics like net present values and economic value added requires the WACC. It is equally important for investors making valuations of companies.

WACC analysis can be looked at from two angles—the investor and the company. From the company’s angle, it can be defined as the blended cost of capital that the company must pay for using the capital of both owners and debt holders. In other words, it is the minimum rate of return a company should earn to create value for investors. From the investor’s angle, it is the opportunity cost of their capital. If the return offered by the company is less than its WACC, it is destroying value, so the investors may discontinue their investment in the company.

IMPORTANCE AND USES OF WEIGHTED AVERAGE COST OF CAPITAL (WACC)

The following points will explain why WACC is important and how it is used by investors and the company for their respective purposes:

Investment Decisions by the Company

WACC is widely used for making investment decisions in corporations by evaluating their projects. Let’s categorize the investments in projects in the following 2 ways:

Importance and Use of Weighted Average Cost of Capital (WACC)Evaluation of Projects with the Same Risk

When the new projects have a similar risk level to existing projects of the company, it’s an appropriate benchmark rate to decide the acceptance or rejection of these projects. For example, a furniture manufacturer wishes to expand its business in new locations, i.e., establishing a new factory for the same kind of furniture in a different location. To generalize this to some extent, a company entering new projects in its own industry can reasonably assume a similar risk and use WACC as a hurdle rate to decide whether it should enter into the project or not.

Evaluation of Projects with Different Risk

WACC is an appropriate measure to evaluate a project, provided two underlying assumptions are true. These assumptions are ‘same risk’ and ‘same capital structure’. What should one do in this situation? WACC can be used with certain modifications, with respect to the risk and target capital structure. Risk-adjusted WACC and adjusted present value etc. are the concepts to circumvent the problems of WACC assumptions.

Discount Rate in Net Present Value Calculations

Net present value (NPV) is the widely used method of evaluating projects to determine the profitability of the investment. WACC is used as discount rate or the hurdle rate for NPV calculations. All the free cash flows and terminal values are discounted using the WACC.

Calculate Economic Value Added (EVA)

EVA is calculated by deducting the cost of capital from the profits of the company. When calculating the EVA, WACC serves as the cost of capital of the company. This is how WACC may also be called a measure of value creation.

Weighted Average Cost of Capital

Valuation of Company

Any rational investor will invest time before investing money in any company. The investor will first try to determine the valuation of the company. Based on the fundamentals, the investor will project the future cash flows and discount them using the WAC; with that, the value of the firm can be calculated. From the Value of Firm, value of debt will be deducted to find the value of equity. Value of equity will be divided by the number of equity shares, leading to the per-share value of the company. One can simply compare this value and the current market price (CMP) of the company to decide whether it is worth the investment or not. If the valuations are more than the CMP, the scrip is under-priced; if it is less than CMP, it is overpriced. If the value is $25 and the CMP is $22, the investor will invest at $22, expecting the prices to rise to $25, or else investment will not be made.

Important Inferences from WACC

Some important inferences from WACC can be drawn to understand various important issues that the management of the company should address.

Effect of Leverage

Considering the Net Income Approach (NOI) by Durand, the effect of leverage is reflected in WACC. Thus, the WACC can be optimized by adjusting the debt component of the capital structure. The lower the WACC, the higher the valuations of the company. A lower WACC also widens the scope of the company by allowing it to accept low return projects and still create value.

Optimal Capital Budgets

The increase in the magnitude of capital also tends to increase the WACC. With the help of a WACC schedule and project schedule, an optimal capital budget can be worked out for the company.

Any analysis using WACC should also consider the advantages and disadvantages of WACC.

Conclusion:

WACC is an important metric used for various purposes, but it must be used very carefully. The weights of the capital components should be expressed in market value terms (Refer: Market vs. Book Value WACC). The market values should be determined carefully and accurately. Faulty calculations of WACC will also result in faulty investment decisions. There are other issues, such as no consideration given to the floatation cost, which should not be ignored. The complications increase if the capital consists of callable, puttable or convertible instruments, warrants, etc.

Last updated on : April 25th, 2019
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3 Comments

  1. Avatar Susurla V S Suresh
  2. Avatar Noma Mtshali
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