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Wacc Decomposed

WACC is the weighted average cost of capital that reflects a company's blended cost of all sources of capital including debt, equity, and preferred shares. It serves as a discount rate for calculating NPV and as a hurdle rate for evaluating potential investments. The WACC is calculated by weighting the cost of each capital component by its percentage of the total capital and summing them. An example is provided to demonstrate calculating WACC using a company with 35% equity, 10% preferred stock, and 55% debt. There are some limitations to using WACC, such as it assumes a stable capital structure and unique calculations between companies.

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Kristi Duran
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69 views

Wacc Decomposed

WACC is the weighted average cost of capital that reflects a company's blended cost of all sources of capital including debt, equity, and preferred shares. It serves as a discount rate for calculating NPV and as a hurdle rate for evaluating potential investments. The WACC is calculated by weighting the cost of each capital component by its percentage of the total capital and summing them. An example is provided to demonstrate calculating WACC using a company with 35% equity, 10% preferred stock, and 55% debt. There are some limitations to using WACC, such as it assumes a stable capital structure and unique calculations between companies.

Uploaded by

Kristi Duran
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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WACC DECOMPOSED

By Farai Mangwende, Business Analyst (Advisory)


Weighted Average Cost of Capital (“WACC”) is the average
blended cost of capital across all diverse sources, including Where:
common stock, preferred shares, and debt. The cost of each ·P = company’s preferred stock
type of capital is weighted as a percentage of the total capital ·Rp = cost of the preferred stock
and they are added together. This article will provide a

decomposition of WACC, highlight its uses, how to calculate Example: Calculating the WACC
it, and will provide examples.
Suppose company ABC has the following capital
Uses of WACC
structure:
WACC acts as the discount rate for calculating a business’s Net
Present Value (NPV). When appraising investment opportunities, 35% equity, 10% preferred stock, and 55% debt. Its
one should use WACC as it reflects the company’s opportunity cost of equity is 12%, its cost of preferred stock is
cost. Thus, it serves as a hurdle rate for most companies i.e., the 9%, and the before-tax cost of debt is 7%.
minimum acceptable rate of return. If the corporate tax rate is 35%, what is the WACC of
company ABC?
Companies often use WACC as the hurdle rate for financial In this example, E/V= 35%, Re= 12%, T = 35%,
modeling of internal investments as well evaluating potential
D/V = 55%, Rd = 7%, P/V = 10%, and Rp = 9%.
transactions such as mergers and acquisitions. If an appraised

investment has a lower Internal Rate of Return (IRR) than the


company’s WACC the investment opportunity should be rejected. And we know that,
Pursuant to that the company would rather initiate a share

WACC=(E/V)Re+((D/V)Rd)(1-T)
repurchase or payout a dividend instead of undertaking the

project. Therefore,

WACC=(E/V)Re+((D/V)Rd)(1-T)
Computation of WACC

The below given formula computes WACC: ABC' s WACC=0.042+0.025025+ 0.009


ABC' s WACC=0.076025=7.6%
Where:
·E = market value of the company’s equity (market cap)
·D = market value of the company’s debt Limitations of WACC
·V = total value of capital (Debt + Equity) Lack of public information: It is hard to calculate
·E/V = percentage of capital that is equity WACC for private companies as the information is
not publicly available.
·D/V = percentage of capital that is debt Change in Capital Structure: WACC assumes that
·Re = cost of equity (required rate of the company’s capital structure remains constant
·Rd = cost of debt (yield to maturity on existing debt) over time. However, the capital structure will vary
·T = corporate tax rate
as the company takes on new projects.
Hard to compare: WACC computation is heavily
To compute WACC we multiply the cost of each source of capital
dependent on the company’s capital structure. As
(debt and equity) by its relevant weight and then adding the
products together. such, it becomes unique to each distinct company.
As such, it is meaningless to compare the WACC
If a company has Preferred stock, then the below extended of one company to the others.
version of the WACC formula becomes useful:

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