WACC is a measure of the cost of capital. Cost of Capital WACC: Examples and Calculation Formula

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

The modern market economy contributes to the formation of the value of the property of any organization. This indicator is created under the influence of various cash flows. In the course of its activities, the company uses its own and borrowed capital. All these cash flows are poured into the organization's funds, form its property.

WACC is a measure of the value of each individual source of funding for a company's operations. This ensures the normal execution of technological cycles. Controlling the cost of capital sources allows you to increase profits. Therefore, this important coefficient is necessarily considered by analysts. The essence of the presented method will be discussed further.

General information

The weighted average cost of capital (WACC) is an indicator that was first considered by analysts in the middle of the last century. It was introduced into use by such famous economists as Miller and Modigliani. It was they who proposed to consider the weighted average cost of capital. This indicatoris still defined as the price of each share of the organization's funds.

To evaluate each source of funding, it is discounted. In this way, the level of profitability is calculated, and then the profitability of the business. At the same time, the minimum amount of payment to the investor for the use of his financial resources in the course of the organization's activities is determined.

The scope of the company's WACC is determined when assessing the capital structure. Its cost is not the same for each category. That is why the price of each source of financing is determined separately. The return is also calculated for each individual category of capital. The difference between these indicators and the cost of attracting them allows you to determine the amount of cash flow. The result is discounted.

Financial sources

The cost of capital WACC, examples and calculation formula of which will be presented below, requires understanding the organization of financing the company's activities. The property managed by the organization is presented in the active side of the balance sheet. The funds that formed these funds (raw materials, equipment, real estate, etc.) are indicated in liabilities. These two sides of the balance are always equal. If this is not the case, there are errors in the financial statements.

First of all, the company uses its own sources. These funds are formed at the stage of creation of the organization. In subsequent years of work, this includes part of the profit (calledunallocated).

Many companies use debt capital. In many cases this makes sense. In this case, the balance model may look like this:

0, 9 + 0, 1=1, where 0, 9 - equity, 0, 1 - loan funds.

Each presented category is considered separately, determining its value. This allows you to optimize the balance structure.

Calculation

As already mentioned, WACC is a measure of the average return on capital. To determine it, a generally accepted formula is used. In the simplest case, the calculation method is as follows:

WACC=DsSs + DzSz, where Ds and Dz are the percentage of equity and debt capital in the overall structure, Cs and Cs are the market value of equity and credit resources.

To take into account income tax, you must supplement the above formula:

WACC=DsSs(1-NP) + DzSz, where NP is income tax.

This formula is most often used by managers, analysts of the organization. The weighted average cost is informative, unlike the average cost of capital.

Discounting

WACC indicator depends on the situation on the capital market. In order to be able to correlate the real state of affairs of the company with the trends existing in the business environment, a discount rate is applied.

The use of each source to finance the company's workassociated with certain costs. Shareholders are paid dividends and creditors are paid interest. This indicator can be expressed as a coefficient or in monetary terms. Most often, the cost of funding sources is presented as a percentage.

The cost of a bank loan, for example, will be determined by annual interest. This is the discount rate. For share capital, this indicator will be equal to the required return that the owners of securities expect from providing their temporarily free funds for the use of the company.

Cost of own sources

WACC is an indicator that primarily takes into account the cost of equity. Every organization has it. Shareholders buy securities by investing them in the activities of their company. At the end of the reporting period, they want to make a profit. To do this, part of the net profit after tax is distributed among the participants. Another part of it is directed to the development of production.

The more a company pays dividends, the higher the market value of its shares will be. However, by not financing funds for its own development, the organization runs the risk of lagging behind its competitors in technological development. In this case, even high dividends will not increase the value of shares on the stock exchange. Therefore, it is important to determine the optimal amount of funding for all funds.

The cost of domestic sources is difficult to determine. Discounting is carried out taking into account the expected profitability of shareholders. She doesn'tshould be less than the industry average.

Aspects of analysis

The WACC cost of capital should be considered in terms of market or balance sheet ratios. If the organization does not trade its shares on the stock market, the presented indicator will be calculated using the second method. For this, accounting data are used.

If the organization forms its own capital through shares that are in free trade, it is necessary to consider the indicator in terms of its market value. To do this, the analyst takes into account the results of the latest quotes. The number of all shares outstanding is multiplied by this figure. This is the real price of the securities.

The same principle applies to all components of an institution's portfolio.

Example

To determine the value of the WACC indicator, it is necessary to consider the presented methodology with an example. Suppose a joint-stock company has attracted financial sources for its work for a total of 3.45 million rubles. It is necessary to calculate the weighted average cost of capital. For this, some more data will be taken into account.

Own financial sources in the company are determined in the amount of 2.5 million rubles. Their yield (according to market quotes) is 20%.

The creditor provided the company with its funds in the amount of 0.95 million rubles. The required rate of return on his investment is about 18%. UsingThe weighted average cost of capital is 0.19%.

Investment project

WACC is an indicator that allows you to calculate the optimal capital structure for a company. Investors seek to invest their free funds in the most profitable projects with the lowest degree of risk. On the part of the company, financing its activities exclusively through its own resources increases stability. However, in this case, the organization loses the benefits from the use of additional sources. Therefore, some part of the borrowed funds must be used by the company for stable development.

The investor evaluates the weighted average cost of capital of the company to determine the appropriateness of the contribution. The company must provide the most acceptable conditions for the creditor. If stability indicators have deteriorated in dynamics, a large amount of debt has accumulated, the investor will not agree to finance the activities of such an organization. Therefore, choosing the optimal capital structure is an important step in the strategic and current planning of any company.

All of the above allows us to conclude that WACC is an indicator of the weighted average cost of financial sources. On its basis, decisions are made on the organization of the capital structure. With the optimal ratio, you can significantly increase the profits of the company's owners and investors.