Weighted Average Cost of Capital (WACC)

 

1. Meaning of WACC

When any company raise any money from market through equity shares, preference shares and debt. Company pays dividend or interest for using their money. Weighted average cost of capital is the average rate of this dividend or interest rate according to weight of equity, preference and debt.

In simple words this average rate is the minimum return which company need to earn for satisfy investors and lenders.

2. Formula

Where:

 

E = Current Market value of Equity

V = Total value (Equity shares + Debt + Preference shares)

D = Current Market value of Debt

P = Current Market value of Preference shares (if any)

Re = Cost of Equity (Ke)

Rd = Cost of Debt

Rp = Cost of Preference shares

Tc = Corporate Tax Rate

 

3. Components

A) How to calculate Cost of Equity (Re)

Most commonly calculated using CAPM model:

Re=Rf+β(Rm−Rf) 

Rf = Risk-free rate (e.g., Govt. bonds)

β (Beta) = Company’s systematic risk

(Rm - Rf) = Market risk premium

Link - Capital Asset Pricing Model

 

B) How to calculate Cost of Debt (Rd)  ​

Since interest is tax deductible, we take after-tax cost = Rd×(1−Tc).

 

C) How to calculate Cost of Preference Shares (Rp)

Rp = 

4. Use of WACC

o   Used as discount rate in DCF (valuation)

o   Helps in capital budgeting decisions (project should earn > WACC)

o   Measures cost of financing and risk

5. 𝗪𝗵𝘆 𝗶𝘀 𝗪𝗔𝗖𝗖 𝗶𝗺𝗽𝗼𝗿𝘁𝗮𝗻𝘁?

o   Helps companies make informed decisions about investments and funding

o   Provides a benchmark for evaluating project returns

o   Essential for determining a company's optimal capital structure

         6. Conclusion

Calculating WACC is an essential skill for finance professionals, and it can help companies make informed decisions about investments and funding. I hope these notes are helpful! Let me know if you have any questions or if you'd like to discuss further.

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