Question

The Weighted Average Cost of Capital (WAAC) is a centerpiece of financial analysis and planning. Please define WAAC and discuss the three main components of WAAC we covered in class and how the computation of their costs differ. Then provide an explanation as to the uses of WAAC by providing at least two perspectives on its usefulness.

Answer 1

The Weighted Average Cost of Capital (WAAC) is the rate expected by all the stakholders of the company who have financed the business. It is the expected return of total funds including equity, preference and long term debts multiplied with the propotion of each of the funds to the total funds.

WACC is calculated as follows:

WACC = (Cost of Equity Shares * Weight of Equity Shares to total fund) + (Cost of Preference shares* Weight of Preference shares to total fund) + (Cost of Debt * Weight of Debt to total fund)

Thus, as can be seen there are three broad components here in WACC calculations:

1. Equity Shares: This represent the common shareholders who have invested into the company. The cost of equity is determined by various methods with popular being the following:

Capital Asset Pricing Model (CAPM), Cost of Equity  = Risk Free Rate + (Beta * (Market Return - Risk Free Rate))

Cost of equity under CAPM considers the volatility of the return with respect to the market return expected. Thus, this implies that the cost of equity is influenced by the external market instead by the management of the company.

Dividend Discount / Growth Model, Cost of Equity = (Dividend next year / Price of the share now) + Growth Rate in earnings

Under this method, cost of equity is calculated as a factor of dividends paid on the equity share with relative to the current market price and including the incremental rate due to growth in future earnings.

2. Preference shares : This represent another form of shareholders who have financed the company. The cost of preference is determined by Dividend next year / Price of the share now.

3. Debt : Debt represents the bonds or any other long term borrowings. These carry a certain fixed periodic coupon rates and also a fixed repayment schedule of the debt. The cost of debt equals the yield expected from the debt when it is held till maturity. Since the coupon or interest payments on debt are tax deductible, cost of debt is the after tax yield to maturity.

Thus, the propotion of financing of each of the above component in a company determines the WACC. For a acceptable WACC, a company has to have a optimum capital structure comprising the three components.

Uses:

WACC is a centerpiece of financial analysis and planning.

This is used by companies to evaluate a future project or an investment. This is the minimum rate a project has to return and thus any project or investment which is expected to yield a return less than WACC will not be accepted.The calculation of various capital budgeting techniques like NPV (Net Present Value) , EVA (Economic Value Added), etc are basis the WACC rate which is used to discount the future cash flows.

WACC is also used by investors to analyse if the return provided by the company they have invested equals its WACC. In other words, WACC is the opportunity cost of capital for the investors. It is used by the investors to value a company. Value of the firm is determined using the future cash flows expected from the company discounted by its WACC. The value of the equity is then determined by deducting the value of debts from the value of firm and value per equity share is then determined by dividing the value of equity with equity shares outstanding. Investors make decision on investments comparing this value per share with the current market price of the company.  

Thus, WACC is a critical measure and companies have to be considerate while choosing their capital structure which needs to be optimal so as to have the minimum possible WACC.