The CIMA defines the weighted average cost of capital “as the average cost of the company’s finance (equity, debentures, bank loans) weighted according to the proportion each element bears to the total pool of capital, weighting is usually based on market valuations current yields and costs after tax”.
Cost of capital is the overall composite cost of capital and may be defined as the average of the cost of each specific fund. Weighted average cost of capital (WACC) is defined as the weighted average of the cost of various sources of finance, weight being the market value of each source of finance outstanding. Cost of various sources of finance refers to the return expected by the respective investors.
A firm may procure long-term funds from various sources like equity share capital, preference share capital, debentures, term loans etc. at different costs depending on the risk perceived by the investors.
When all these costs of different forms of long-term funds weighted by their relative proportions to get overall composite cost of capital termed as ‘weighted average cost of capital (WACC)’. The firm’s WACC should be adjusted for the risk characteristics of a project for which the long-term funds are raised. Therefore, project’s cost of capital is WACC plus risk adjustment factor.
The argument in favour of using WACC stems from the concept that investment capital from various sources should be seen as a pool of available capital for all the capital projects of an organization. Hence cost of capital should be weighted average cost of capital. Financing decision, which determines the optimal capital mix, is traditionally made without making any reference to WACC.
Optimal capital structure is assumed at a point where WACC is minimum. For project evaluation, WACC is considered as the minimum rate of return required from project to pay off the expected return of the investors and as such WACC is generally referred to as the ‘required rate of return’. The relative worth of a project is determined using this required rate of return as the discounting rate. Thus, WACC gets much importance in both the decisions.
The simple WACC is calculated without consideration to the impact of tax on cost of capital. The combined cost of equity capital and debt capital is the WACC for a company as whole. If the company is all equity financed, the cost of equity will be the cost of capital.
In case of geared companies, the WACC can be stated as follows:
WACC = (Cost of Equity x % Equity) + (Cost of Debt x % Debt)
ABC Ltd. has a gearing ratio of 40%. Its cost of equity is 21% and the cost of debt is 15%.
Calculate the company’s WACC.
WACC = (21% x 0.60) + (15% x 0.40) = 12.6% + 6% = 18.6%
The required rate of return on equity is 16% and cost of debt is 12%. The firm has a capital structure mix of 60% of equity and 40% debt. What is the overall rate of return of the firm should earn?
This means suppose the total project cost or investments made by the firm is Rs. 10,00,000 (Rs. 6,00,000 equity and Rs. 4,00,000 debt). Company must earn 14.496 on its overall investments i.e., Rs. 1,44,000 which will be just sufficient to give equity holders a rate of return of 1696.
The weighted average cost of capital of a company is calculated in two ways:
(i) Based on weight of costs by the book value of the different forms of capital.
(ii) Based on weight of market value of each form of capital.
Market Value of Funds and WACC:
The market value approach is more realistic for the reasons given below:
(a) The cost of funds invested at market prices is familiar with the investors.
(b) Investments are generally rated by the reference to their earnings yield, and the company has a responsibility to maintain that yield.
(c) Historic book values have no relevance in calculation of real cost of capital.
(d) The market value represents near to the opportunity cost of capital.
WACC is the discount rate that can be used to evaluate the company’s new investments, provided that they have the same risk profile as the company as a whole and provided that they used the same combination of debt and equity to finance the proposed investments, or financed by company reserves.
Calculate the company’s weighted average cost of capital based on both market values and book values.
Cost of individual sources of capital is net of tax.
WACC and Tax Shields:
After taking the tax shields into account, the following formula is applied for calculation of WACC.
Ke = Cost of equity capital
Kd = Cost of debt
E = Market value of equity capital
D = Market value of debt
T = Corporate tax rate
The simplified version of the above formula is given below:
WACC = (Cost of Equity x % of Equity) + [Cost of Debt (1 – Tax rate) x % of Debt]
The percentage of equity and debt represents the gearing of the company. The tax rate is corporate rate of tax payable by the company from profits.
Good Health Ltd. has a gearing ratio of 30%. The cost of equity is computed at 21% and the cost of debt 14%. The corporate tax rate is 40%. Calculate WACC of the company.
WACC = (21% x 0.70) + [14% (1 – 0.40) x 0.30]
= 14.70% + 2.52% = 17.22%