The Definition of ‘Weighted Average Cost of Capital
The “weighted average cost of capital” may be defined as the average rate that a company should expect to pay to all its security holders to finance its assets. Conversely, with the same meaning, it is the minimum expected rate of return that a company must earn on its existing asset base to satisfy its owners, investors and every other providers of capital. If the company fails to earn this average rate, it fails to recover its cost of capital.
Why ‘Weighted Average Cost of Capital is Calculated?
A company’s assets are financed either by debt or equity. The cost of procuring these funds may vary according to different situations and circumstances under which they are sought for. When the fund is collected through equity, the equity share owners become proportionate owner of the company. If any fund is collected through debt instrument, the providers of debt fund become the lenders to the company. Both of these two ways of collecting funds are again may be divided in sub-groups. The fund may be collected through shares in modes other that equity shares like Preference share with different rate of interests (e.g., 1%, 5%, 7%, etc) at different times under different repayment options. Similarly, debt funds can be also collected under different payment options with different interest rates. The ‘Weighted Average Cost of Capital’ of these sources of financing gives respective weights to their respective use in a given situation. The ‘Weighted Average Cost of Capital’ is the overall required return on the firm as a whole and it is extensively used in case of considering an investment proposal or in determining the economic feasibility of expansionary opportunities and mergers.
Thus, the ‘Weighted Average Cost of Capital’ is the logical price tag to put on an investment to make worthwhile. It is a measure of proportional capital cost to businesses and corporations seeking an assessment of multiple forms of capital infusion. Some benefits of calculating ‘Weighted Average Cost of Capital’ as mentioned below:
- It helps to determine the use of debt in finance activities (capital leverage)
- It assists to determine percentage cost for each capital components
- It has good application in Discounted Cash Flow (DCF)
- It helps in financial analysis
- Strategic planners, shareholders and investors can determine financial positioning
How to Calculate the Weighted Average Cost Of Capital (WACC)?
The first step in calculating WACC you should know the percentage proportion of each form of capital in money value and each components cost. There are many ways of calculating cost of equity. The most frequently used method is the return that equity owners expect to get in each unit. Here, in the example shown below, we have taken that expected return as 10%.For example; a company has following capital mix: equity (50%), Debenture (20%) and Preference Share (30%). Each of these forms of capital has different costs like Equity in dividend (10%), Debenture interest (6%) and Preference Share return (5%). Suppose the company has total capital of $1000. Therefore, weights are calculated based on the amount of capital invested by each category of capital in comparison to the total capital i.e. $1000.
First we need to calculate the weights of and equity debenture.
Market Value of Equity = $500
Market Value of Debt = $200
Preference Share = $300
Total Market Value of Equity, Debenture and Preference Share = $1,000
Weight of Equity = $500 / $1000 = 50
Weight of Debenture= $200 / $1000 =20; and
Preference Share= $30/$1,000= 30
Weight of Preference Share =$300 / $1000 =30%
Now, the weighted average cost of capital will be calculated as follows:
|Type of Capital||Cost of Capital||Amount of Capital||Weights||Weighted Cost(Weight X Cost) ÷ Weight|
The Weighted Average Cost Of Capital= 12.7%