Weighted Average Cost of Capital (WACC) is an important term to understand the actual cost of capital of the company. Here I would like to explain cost by using an example, let’s suppose that you have a certain amount of money and there are two choices either you can spend that amount buying something or you can deposit that amount in a savings bank account. A savings bank account gives you the interest of 6%, so if you spend that money buying something, you are paying a cost of 6% i.e., the interest rate you would have got if that particular amount has been deposited in a savings bank account. Similarly, a business needs to pay a cost for raising funds.
For example, a company can choose various options to raise funds for itself :
Option 1- 100% loan from a bank (interest- 12%)
Option 2- 100% Equity (dividend- 20%)
Option 3- 50% loan + 50% equity
If a company wants to raise funds through option 1 i.e. through the loan, it has to pay the cost in terms of interest to the bank. If it chooses equity it has to pay the cost in terms of dividend to its shareholders. In 3rd option, a company can opt for raising funds using both loan and equity (ideally the company must have D/E<2). To calculate the weighted average cost of capital of all the sources from where the funds have been raised as mentioned in option 3 we can use the formula mentioned below:
WACC = % of Equity* Cost of Equity (Dividend) + % of Debt* Cost of Debt (Interest)
= 50%*20% + 50%*12% = 16%
The options mentioned above are just to understand the basics of WACC and are not exhaustive. There are other sources of raising funds such as preference shares or even through internal financing through retained earnings.
For Example, a company wants to raise ₹1 crore to finance its operations. It has many options and can use a mix of different sources.
- Preference Shares = 25L
- Equity Shares = 35L
- Bonds = 15L
- Bank loan = 25L
To calculate the WACC we can use this formula:
WACC= [% of preference share capital* Cost of preference shares (Dividend %)] + [% of Equity Shares* Cost of Equity shares (Dividend %)] + [% of Bonds* Interest%(1-T)] + [% of Bank Loan* Interest%(1-T)]
Here, (1-T) refers to the deduction due to taxes that company pays to the Government, if they chose to raise funds by raising their debts.
WACC is useful for both: a businessman and an investor.
If a businessman chooses to take a new project, he has to go through the Internal rate of return of the new project because the return from that new project must be higher than the present WACC of that company.
The investor uses WACC to analyse if the company is making a healthy debt-equity mix.
Cost of Equity>WACC>Cost of debt
The above statement clearly defines the Healthy equity-debt mix. If the company’s Cost of Debt is more than the cost of equity it clearly states that the company carries a lot of risks because bank demands the repayment of loan irrespective of loss and profit of the company, the cost of equity also contains the higher risk because it involves the investor’s expectation of higher returns. Calculating the WACC helps the investors to understand how much amount to be invested in the company because it helps to reduce the risk of the investor.
The investor should calculate the WACC of a company before investing into a particular company. For the businesses as well it is important to calculate WACC before investing into a particular project so WACC plays an important role in making an investing decision.