A company is raising funds from different sources of finance and with that it is doing business. Company has a responsibility to give return to fund providers. If company has only one source of finance, then it is the rate at which it is required to earn from the business. However, it may have raised funds from more than one source of finance, in that case WACC (Weighted Average Cost of Capital) is required to be found, which indicates minimum rate at which, company should earn from the business so as to give return to finance providers as per their expectations. The importance and usefulness of weighted average cost of capital (WACC) as a financial tool for both investors and the companies are well accepted among the financial analysts. It is important for companies to make their investment decisions and evaluate projects with similar and dissimilar risks. Calculation of important metrics like net present values and economic value added requires WACC. It is equally important for investors for arriving at 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 which the company has to 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 the investors. From 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 and hence, the investors may discontinue their investment in the company.
Table of Contents
- 1 IMPORTANCE AND USES OF WEIGHTED AVERAGE COST OF CAPITAL (WACC)
- 2 Important Inferences from WACC
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 Company
WACC is widely used for making investment decisions in the corporate by evaluating their projects. Let us categorize the investments in projects in the following 2 ways:
Evaluation of Projects with the Same Risk
When the new projects are of similar risk like existing projects of the company, it is 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 it to some extent, a company entering new projects in its own industry can reasonably assume the 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 be used to evaluate a project provided two underlying assumptions are true. The assumptions are ‘same risk’ and ‘same capital structure’. What to do in this situation? Still, WACC can be used with certain modification with respect to the risk and target capital structure. Risk-adjusted WACC, 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. In 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.
Valuation of Company
Any rational investor will invest time before investing money in any company. The investor will try to find out the valuation of the company. Based on the fundamentals, the investor will project the future cash flows and discount them using the WACC and with that value of firm can be calculated. From Value of Firm, value of debt will be deducted to find value of equity. Value of equity will be divided by number of equity shares. He will get the per-share value of the company. He can simply compare this value and the current market price (CMP) of the company and decide whether it is worth investment or not. If the valuations are more than the CMP, the scrip is under-priced and if it is less than CMP, it is overpriced. If the value is $25 and CMP is $22, the investor will invest at $22 expecting the prices to rise till $25 otherwise 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. So, the WACC can be optimized by adjusting the debt component of the capital structure. Lower the WACC, higher will be the valuations of the company. 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 tends to increase the WACC as well. With the help of WACC schedule and project schedule, an optimal capital budget can be worked out for the company.
The analysis using WACC should also consider the advantage and disadvantages of WACC.
WACC is an important metric used for various purposes but it has to 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 result in faulty investment decisions as well. There are issues such as no consideration given to the floatation cost which is not worth ignoring. The complications increase if the capital consists of callable, puttable or convertible instruments, warrants etc.Last updated on : November 13th, 2018