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Module 4 - WACC

The document discusses the weighted average cost of capital (WACC), which is an important figure for assessing a company's financial health. WACC is calculated by weighting the cost of each component of a company's capital structure by its proportion of the total capital. WACC can be used as a hurdle rate for investment decisions and to determine the optimal capital structure that minimizes a company's financing costs. The document provides examples of calculating WACC based on given capital structures and costs of debt and equity. It also discusses how WACC can help identify the most profitable projects for a company to undertake.

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Kyrha Joy Layson
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69 views

Module 4 - WACC

The document discusses the weighted average cost of capital (WACC), which is an important figure for assessing a company's financial health. WACC is calculated by weighting the cost of each component of a company's capital structure by its proportion of the total capital. WACC can be used as a hurdle rate for investment decisions and to determine the optimal capital structure that minimizes a company's financing costs. The document provides examples of calculating WACC based on given capital structures and costs of debt and equity. It also discusses how WACC can help identify the most profitable projects for a company to undertake.

Uploaded by

Kyrha Joy Layson
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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WEIGHTED AVERAGE COST OF CAPITAL

(WACC)
OBJECTIVES
ØDiscuss what is Weighted Average Cost of
Capital (WACC).

ØDescribe the importance of WACC.

ØExplain how to calculate and determine


WACC.
WEIGHTED AVERAGE COST OF CAPITAL

ØWeighted Average Cost of Capital (WACC) is one of the


most important fIgures in assessing a company’s
financial health, both for internal use (in capital
budgeting) and external use (valuing companies on
investment markets).
• Capital budgeting involves choosing projects that add
value to a company. The capital budgeting process can
involve almost anything including acquiring land or
purchasing fixed assets like a new truck or machinery.
WEIGHTED AVERAGE COST OF CAPITAL

ØWeighted Average Cost of Capital (WACC) gives


companies an insight into the cost of their financing,
can be used as a hurdle rate for investment decisions,
and acts as a measure to be minimized to find the best
possible capital structure for the company.
• A hurdle rate is the minimum rate of return required on
a project or investment. Hurdle rates give companies
insight into whether they should pursue a specific
project.
WEIGHTED AVERAGE COST OF CAPITAL

ØWeighted Average Cost of Capital (WACC) is a rough


guide to the rate of interest per monetary unit of capital.
ØBy changing the capital structure, a company can raise
or lower its WACC.
ØIt is calculated by averaging the rate of all of the
company’s sources of capital (both debt and equity),
weighted by the proportion of each component.
ØA firm’s average cost of capital, weighted to reflect that
different sources of capital, like common stock and bonds,
carry different return expectations.
WACC Formula
Example#1

A company wants to raise money, the company will sell $10M of common stock,
the expected return is 15%. Moreover, the company will issue $5 million of debt,
the cost of debt is 12% and the tax rate is 30%. Find the WACC.
Example#2

ABC Company decided to raise funds of $100,000 to grow their business.


They decided to issue bonds worth 30,000 and equity of 70,000. Cost of
debt is 4% with corporate tx of 25% and the cost of equity is 10%.
Example#3
The following is the capital structure of a company.
Source Amount Before tax cost (%)
Equity capital 300,000 15
Retained earnings 200,000 13
Preference capital 150,000 16
Debentures 350,000 12
Assume tax rate at 30%. Compute weighted average cost of capital.
Example#4

ABC Ltd. Is planning for the most desirable capital structure. The
cost of debt (after tax) and equity capital at various levels of debt
and equity mix is estimated as follows.

Determine the composite cost of capital for each level of debt and
equity and identify the optimum capital structure.
Solution
The optimum debt equity mix in this problem would be with 40% debt and 60% equity, as the
total cost of this combination is the least when compared to other options ie 13.80%
Ø The optimal capital structure of a firm is the best mix of debt
and equity financing that maximizes a company’s market
value while minimizing its cost of capital.
Ø In theory, debt financing offers the lowest cost of capital due
to its tax deductibility.
Ø However, too much debt increases the financial risk to
shareholders and the return on equity that they require.
Ø Thus, companies have to find the optimal point at which the
marginal benefit of debt equals the marginal cost.
Øa lower WACC indicates a healthy business
that’s able to attract investors at a lower cost.

Øa higher WACC usually coincides with


businesses that are seen as riskier and need to
compensate investors with higher returns.
Example #5
Example#2 - WHAT IF
WACC is also important when analyzing the potential benefits of taking
on projects or acquiring another business.

Project 2 = Expected return is


WACC = 7.9%
Which is better project?

Project 1
6% - 7.9% = -1.9%

17.9% - 7.9% = 10%


1. https://www.bdc.ca/en/articles-tools/entrepreneur-toolkit/templates-business-
guides/glossary/weighted-average-cost-of-
capital#:~:text=The%20weighted%20average%20cost%20of,the%20proportion
%20of%20each%20component.
2. https://www.investopedia.com/terms/w/wacc.asp
3. https://www.investopedia.com/articles/financial-theory/11/corporate-project-
valuation-methods.asp
4. https://gfgc.kar.nic.in/punjalakatte/GenericDocHandler/199-19aaa130-cdcb-
4d3d-ba54-8e73a2d271dd.pdf

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