Wednesday, 18 January 2012

Weighted Average Cost of Capital

Weighted Average Cost of Capital Definition:
Weighted average cost of capital, defined as the overall cost of capital for all funding sources in a company, is used as commonly in private businesses as it is in public businesses.

A company can raise its money from three sources: equity, debt, and preferred stock. The total cost of capital is defined as the weighted average of each of these costs.


Weighted Average Cost of Capital Meaning:
Weighted average cost of capital means an expression of the overall requited return on the company’s investment. It is useful for investors to see if projects or investments or purchases are worthwhile to undertake. It is equally as useful to see if the company can afford capital or to indicate which sources of capital will be more or less useful than others. It has also been explained as the minimum return a company can make to repay capital providers.

Weighted Average Cost of Capital Formula:
The most popular method to calculate cost of capital is through using the Weighted Average Cost of Capital formula.

WACC = Ke *(E/(D+E+PS)) + Kd*(D/(D+E+PS))*(1-T) + Kps*(PS/(D+E+PS))

Where

Ke = cost of equity

Kd = cost of debt

Kps= cost of preferred stock

E = market value of equity

D = market value of debt

PS= market value of preferred stock

T = tax rate

Ke reflects the riskiness of the equity investment in the company. Kd reflects the default risk of the company, and Kps reflects its intermediate standing in terms of risk between debt and equity. The weights of each of these components reflect their market value proportions and measure how the existing company is financed.


Weighted Average Cost of Capital Calculation:
Weighted average cost of capital calculation, though sometimes complex, will yield very useful results.

Example: a company finances its business 70% from equity, 10% from preferred stock, and 20% from debt. Ke is 10%, Kd is 4%, and Kps is 5%. The tax rate is 30%. The required rate of return of this company according to the WACC is:

(70% * 10%) + (20% * 4%) + (10% * 5%) = 8.3%

That means the required return on capital is 8.3%. A company pays 8.3% interest for every dollar it finances.


Weighted Average Cost of Capital Examples:
Tim is creating a web 2.0 startup business called Webco. Tim, an avid user of the web and recent college graduate, has quite a bit to learn. He relies off of his networking ability and mentors to receive much needed advice.

Tim has prepared a full business plan. He is now moving his company to the next level by beginning to find capital providers. He has an expected range of the returns each source of available capital will require. Now, Tim needs to use the weighted average cost of capital method to decide whether his company will be able to receive capital from certain providers.

After doing some research, Tim is prepared to make his calculation. His results are below:

Tim's company is considering finaning its business 70% from equity, 10% from preferred stock, and 20% from debt. Ke is 10%, Kd is 4%, and Kps is 5%. The tax rate is 30%.

(70% * 10%) + (20% * 4%) + (10% * 5%) = 8.3% = WACC

That means the required return on capital is 8.3%. A company pays 8.3% interest for every dollar it finances.

Tim's company, according to his calculations, will not be able to create the returns required to work with the mix of capital which is listed above. He resolves to do more research and come back at the problem with a new approach.

Overall, Tim is satisfied. Though he has not seen the results that he was looking for, he was able to avoid a costly mistake by creating a plan before he began. He has confidence that despite this setback his career has a bright future.

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