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Notes WACC

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26 views

Notes WACC

Uploaded by

Naman Mishra
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as RTF, PDF, TXT or read online on Scribd
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What is WACC?

WACC is a financial metric that calculates a company's average cost of capital from all
sources, weighted according to their proportion in the company's capital structure. It
represents the average rate of return a company must earn on its existing assets to maintain its
current value.

Key Components of WACC

1 Cost of Equity (Re):

◦ Definition: The return required by equity investors given the risk of the investment.
◦ Calculation: Often estimated using the Capital Asset Pricing Model (CAPM):Re=Rf+β×(Rm
−Rf)Re=Rf+β×(Rm−Rf) where:
RfRf = Risk-free rate (e.g., yield on government bonds)
ββ = Beta coefficient (measures the stock's volatility relative to the market)
RmRm = Expected market return
2 Cost of Debt (Rd):

◦ Definition: The effective rate that a company pays on its borrowed funds.
◦ Calculation: Typically the yield on debt or interest rate on loans, adjusted for tax benefits
(since interest is tax-deductible):After-Tax Cost of Debt=Rd×(1−Tc)After-
Tax Cost of Debt=Rd×(1−Tc) where TcTc = Corporate tax rate
3 Equity and Debt Proportions:

◦ Equity Proportion (E/V): The fraction of the company’s capital structure that comes from
equity.
◦ Debt Proportion (D/V): The fraction of the company’s capital structure that comes from
debt.
◦ V: Total value of the company’s financing (Equity + Debt).
WACC Formula

The WACC formula combines these components into a single measure:

WACC
=
(
E
V
×
R
e
)
+
(
D
V
×
R
d
×
(
1
−
T
c
)
)
WACC=(VE ×Re)+(VD ×Rd×(1−Tc))
where:

• EVVE = Proportion of equity in the capital structure


• ReRe = Cost of equity
• DVVD = Proportion of debt in the capital structure
• RdRd = Cost of debt
• TcTc = Corporate tax rate
Interpreting WACC

1 Risk and Return: WACC reflects the riskiness of a company’s cash flows. Higher WACC
indicates higher risk and thus higher expected returns. A lower WACC suggests lower risk
and a lower required return.

2 Investment Decisions: WACC is used as a discount rate in DCF models to evaluate


investment opportunities. If a project’s expected return exceeds the WACC, it is likely a good
investment.

3 Capital Structure Impact: Companies with a higher proportion of debt (compared to equity)
usually have a lower WACC because debt is generally cheaper than equity and interest
payments are tax-deductible. However, too much debt can increase financial risk.

4 Comparative Analysis: Comparing WACC across companies or industries helps assess


relative risk and return profiles.

By understanding each component of WACC and how they interact, you can better evaluate a
company's cost of capital and make informed financial decisions.

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