The weighted average cost of capital or simply WACC is a way to measure a company’s value based on its profitability. It can be calculated with our Weighted Average Cost of Capital Calculator.
To get your head around the idea of WACC, we can begin with a simple example:
Consider this, you’re an entrepreneur with plans for a start-up company! you contact a bank to borrow a loan for the start off. The bank analyzes your plan and green lights the loan. However, bank conditions the loan with an 8% interest that you need to pay over and above the total capital that you’d borrow.
Now if you agree to the condition and borrow the loan, this interest rate is your company’s cost of capital.
Companies need a heck of a lot of money to source their product or service. This capital comes in the form of bank loans, venture capital and shareholdings.
But these big investments come at a cost, and that is what we call cost of capital of a company. If an enterprise has more than one source of investments, we need to take the WACC into consideration.
It’s an internal measurement of an enterprise’s cost of capital. And when investors want to know whether it’s profitable to invest in a company or not, they calculate WACC of the given firm.
For instance, investor X considers investing in fir Y. Now X realizes that the WACC of this company Y is 9% while the return on wealth at the conclusion of the period is 8%.
As can be seen, the return on the wealth of 8% is lower than the WACC of 9% by a factor of 1. Now, assuming that X is rational, the decision to invest in the company would be canceled as the value X will get after pouring in investment is less than the weighted average cost of capital.
This is because WACC is the gauge against which a company’s profitability is measured. If the rate of return of the given company is higher than it’s WACC, that means that the firm is profitable, if it is lower than the weighted average cost of capital, that simply means, the company is not profitable.
Most Investors don’t measure the WACC due to the calculation complexity. This is the reason why we have developed the cost of capital calculator to facilitate investors in their ventures. However, if you are of the curious ones, here’s the formula for wacc:
\( \text{WACC} = \left( \dfrac{E}{V} \times Ke \right) + \left(\dfrac{D}{V}\right) \times Kd \times (1 - \text{Tax rate})\)
Where,
E: stands for Market Value of Equity
V: stands for the total market value of debt and equity
Ke: stands for the cost of equity
D: stands for the market value of debt
Kd: stands for the cost of debt
Whereas,
Tax Rate is simply, Corporate Tax Rate.
As has been mentioned above, the manual WACC calculation is difficult. This is why we have developed this tool that makes calculating wacc a walk in the park.
Below, we have outlined the simple steps to follow for the purpose of the weighted average cost of capital calculation in this digital gizmo of ours.
Let’s consider that your company’s start-up’s percentages of equity are 30% and 40% respectively while the percentage of the corporate tax rate is 30%.
On the other hand, the amount of equity is 30,000 and debt is 40,000. Putting these values in the respective boxes in our calculator, we press ‘calculate’.
The WACC for this startup after calculation turns out to be 28.86%, calculated in less than 2 seconds.
There are two main components in a company’s cost of capital, the debt and equity, as has been discussed in detail above.
However, there are certain advantages and disadvantages to both of these. We have discussed them briefly below:
Advantages:
Rights of voting.
upper bound on profits’ share.
interest expenditures are tax deducted.
Disadvantages:
legal obligations to to repayment regardless of financial conditions.
More debt borrowing is equivalent t more financial risks.
Advantages:
no legal obligation for payment
less financial risk
Disadvantages:
if equity is too much it increases the potential of buyouts by other firms
There are no tax shields.
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