Question

Discus the three pairs of elements of the weighted average cost of capital formula. What does the WACC denote? (For example, what does the WACC = 9.7% suggest to the analyst?) Which WACC element, if any, is calculated “after tax”? Why? What does this suggest about using this asset class, courtesy of the US government?

Answer 1

An organisation can used different sources like debt and equity to finance itself. Weighted Average Cost of Capital(WACC) can be defined as the average rate of return that the company is expecting to pay its investors like equity investors and bond holders. The formula for WACC is:

WACC = Proportion of equity x Cost of Equity + Proportion of Debt x Cost of Debt - Tax Benefit on Debt

Hence, three elements are:

Equity Cost: This is the cost that the company is paying to its equity investors for the proportion of finance raised as equity.

Debt Cost: This is the cost that the company is paying to its debt investors for the proportion of finance raised as equity.

Tax Benefit: Since interest on debt is tax-free, we need to deduct the tax benefit from the total cost.

WACC=9.7% suggests that the organisation is paying on an average 9.7% for raising the funds from market. Hence, any activity that company performs to generate the capital must give a return higher than 9.7%. The equity element is used in the formula after adding the tax. This infers that government is incentivizing companies to use debt more than equity since from investor's perspective, equity is more riskier investment.