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ConceptsCoach, Certified Public Accountant (CPA)

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What is meant by WACC What are some components of WACC When

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What is meant by WACC? What are some components of WACC? When is WACC an appropriate discount rate when doing capital budgeting? What is the effect on WACC when an organization raises long-term capital?

Finance involves two key areas for decision-making: procurement of funds and application of funds. In effect, both the decisions are critical from a company's standpoint. Company is willing to invest in a new project as long as it increases the shareholder's wealth and generates a reasonable return over the cost of procuring the capital.

Let us suppose a company decides to invest in a project which involves application of funds decision as per above. Although it's impossible to predict the future cash flow to be generated if the project is undertaken, however, based on certain assumptions and probabilities future cash flows are calculated for the tenure of the project involved. Initial investment is known with certainty as its required in year zero.

Looking at the above situation one thing is clear that you cannot simply add up all the predicted future cash inflows and subtract the sum from the initial investment to come to a decision as to the project's viability. The simple reason behind this is that as time passes by the real value of money deteriorates. Therefore, it's safe to conclude that money has time value and an individual would prefer a dollar today as compared to a dollar a year later. Simply, because of two strong reason: Inflation drops the purchasing power of a dollar a year down the line and interest can be earned if the dollar is invested today to generate interest + principal a year hence. So all the future cash flows occurring at different point in times need to be discounted back to year zero and aggregated in order to evaluate the viability of the proposed project. This throws an obvious question as to what discounting rate to be used? Answer to that is Weighted Average Cost of Capital or popularly known as WACC.

Broadly speaking a company has two major ways in which it can finance the capital requirement of its new project: debt and equity. Since the company needs to pay back interest to the debt-holders (cost of debt) and dividends to the equity-holders (cost of equity), together they form the total cost of capital procurement from the companies' standpoint. Usually a company uses a mix of both debt and equity to fund its new project and hence we need to find the weights of individual source of funds (debt or equity) in order to calculate the WACC. Now how do we measure weights, it's simply the market value of a source divided by the total market value of the firm. It is important to note that market value weights are considered here rather than book value since we are calculating the expected cost of the capital to be invested in the new project. WACC is then calculated by simply multiplying the cost of respective source with its respective market based weights in the total capital structure of the company. WACC takes into consideration the overall cost of capital of the company while evaluating the project's viability.

WACC is calculated as follows:

WACC = [{cost of debt * (1-t) * D/V} + {cost of equity * E/V}]

Where D = Value of Debt

E = Value of Equity

V = Total Value of Firm

Cost of debt = Interest rate required by debt-holders.

Cost of Equity = Expected rate of return calculated using the CAPM model.

A closer look at the above formula shows that a company can lower its overall cost of capital or the WACC if it increases the debt component in its capital structure vis-a-vis equity. This is because interest is a tax-deductible expenditure while dividend is not. In other words, increase in debt will involve more interest expense, which is an allowable expense while calculating corporate tax and hence saves tax to a certain extent. If that is to be true why company do not heavily rely on debt financing. Well, simply because the more debt in the capital structure exposes the company to higher risk of financial distress. Therefore, the challenge often faced by firms is to have appropriate level of debt and equity to reduce the overall cost of capital without jeopardizing the overall financial health of the firm.

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What is meant by WACC? Weighted Average Cost of Capital

What are some components of WACC?

WACC = [{cost of debt * (1-t) * D/V} + {cost of equity * E/V}]

Where D = Value of Debt

E = Value of Equity

V = Total Value of Firm

Cost of debt = Interest rate required by debt-holders.

Cost of Equity = Expected rate of return calculated using the CAPM model.

When is WACC an appropriate discount rate when doing capital budgeting?

It is an appropriate discount rate when you capital structure include debt and equity. Broadly speaking a company has two major ways in which it can finance the capital requirement of its new project: debt and equity. Since the company needs to pay back interest to the debt-holders (cost of debt) and dividends to the equity-holders (cost of equity), together they form the total cost of capital procurement from the companies' standpoint. Usually a company uses a mix of both debt and equity to fund its new project and hence we need to find the weights of individual source of funds (debt or equity) in order to calculate the WACC. Now how do we measure weights, it's simply the market value of a source divided by the total market value of the firm. It is important to note that market value weights are considered here rather than book value since we are calculating the expected cost of the capital to be invested in the new project. WACC is then calculated by simply multiplying the cost of respective source with its respective market based weights in the total capital structure of the company.

What is the effect on WACC when an organization raises long-term capital?

A company can lower its overall cost of capital or the WACC if it increases the debt component in its capital structure vis-a-vis equity. This is because interest is a tax-deductible expenditure while dividend is not. In other words, increase in debt will involve more interest expense, which is an allowable expense while calculating corporate tax and hence saves tax to a certain extent. If that is to be true why company do not heavily rely on debt financing. Well, simply because the more debt in the capital structure exposes the company to higher risk of financial distress. Therefore, the challenge often faced by firms is to have appropriate level of debt and equity to reduce the overall cost of capital without jeopardizing the overall financial health of the firm.

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Thanks for your help, however, the answer that i'm looking for is not copied and pasted from the internet. I can get the answer from the internet myself. What I'm looking for is a non-dictionary response. If you can re-write it that's great, if you can't I understand. Thanks

I assure you its not a copy paste. Its my own written article on WACC. If you still don't trust me, clearly specify how can I make it more simplified for you:)

Thanks

Edited by ConceptsCoach on 8/21/2010 at 10:38 PM EST