Weighted Average Cost of Capital

What is Weighted Average Cost of Capital?

Weighted average cost of capital (WACC) is the calculation of a companys cost of
capital whereby every source of capital is proportionately weighted.
Weighted average cost of capital (WACC) is the average rate of return a company
expects to compensate all its different investors.

Basic Formula
WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-Tc)]
(Percentage of finance that is equity x Cost of Equity) + (Percentage of
finance that is debt x Cost of Debt) x (1 Tax Rate)
E = Market value of the company's equity
D = Market value of the company's debt
V = Total Market Value of the company (E + D)
Re = Cost of Equity
Rd = Cost of Debt
Tc= Tax Rate

Uses of Weighted Average Cost of Capital

It may be used for discounting cash flows in determination of net present

value for investment analysis.

Some firms use WACC to check if the investment projects that are available

are worthwhile to take on.

Securities analysts use WACC when assessing and choosing investments.
Weighted average cost of capital also helps determine the feasibility of
expansion as well as mergers.

Why it Matters:

It's important for a company to know its weighted average cost of capital as a

way to gauge the expense of funding future projects.

The lower a company's WACC, the cheaper it is for a company to fund new
projects.

A company looking to lower its WACC may decide to increase its use of
cheaper financing sources.

Net Present Value

To discount you go to the left from FV and calculate the PV, this is called
discounting.

Net Present Value is the present value of net cash inflows generated by
a project including salvage value, if any, less the initial investment on
the project. It is one of the most reliable measures used in capital
budgeting because it accounts for time value of money by using

discounted cash inflows.

Before calculating NPV, a target rate of return is set which is used to
discount the net cash inflows from a project. Net cash inflow equals
total cash inflow during a period less the expenses directly incurred on
generating the cash inflow.

Calculation Methods and Formulas

The first step involved in the calculation of NPV is the determination of

the present value of net cash inflows from a project or asset.

The net cash flows may be even (i.e. equal cash inflows in different

periods) or uneven (i.e. different cash flows in different periods).

When they are even, present value can be easily calculated by using

the present value formula of annuity.

However, if they are uneven, we need to calculate the present value of

each individual net cash inflow separately.

In the second step, we subtract the initial investment on the project
from the total present value of inflows to arrive at net present value.

Thus, we have the following two formulas for the calculation of NPV:
When cash inflows are even:
NPV = R 1 (1 + i)-n Initial Investment
In the above formula,

R is the net cash inflow expected to be received each period;

i is the required rate of return per period;
n is the number of periods during which the project is expected to operate
and generate cash inflows.

When cash inflows are uneven:

Where,

i is the target rate of return per period;

R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period;
R3 is the net cash inflow during the third period, and so on ...

Decision Rule

Accept the project only if its NPV is positive or zero.

Reject the project having negative NPV.
While comparing two or more exclusive projects having positive NPVs,
accept the one with highest NPV.

Advantage and Disadvantage of NPV

Advantage:
Net present value accounts for time value of money. Thus, it is more reliable
than other investment appraisal techniques which do not discount future
cash flows such payback period and accounting rate of return.

Disadvantage:

It is based on estimated future cash flows of the project and estimates may
be far from actual results.

Internal Rate of Return (IRR)

Meaning:
Internal rate of returns is that rate at which the sum of discounted cash
inflow equals the sum of discounted cash outflow. In other words, it is the
rate which discounts the cash flow to zero.

Accept/reject criterion
The acceptance and rejection is done on the basis of the IRR rate.

Comparison of IRR with NPV

NPV
(a) It takes interest as a known factor
(b) It calculates the exact

IRR
(a) It takes interest as a- unknown factor
(b) It calculates maximum

Conflicts:

The project requires different cash outlay.

The project has unequal lives.
The project has different pattern of cash flows.

Merits &demerits:

Consider the time value of money.

Take the amount of expenses &revenue.
Gives more value to the present money value.
It is very difficult.
Reinvestment presumption.

Overview

You need to know the internal rate of return on any investment may be to

figure out if it is really worthwhile.

The internal rate of return on the investment determined by looking into the

future and finding out the true value today.

Sometimes it is better to look at the net present value if you want to see

what your net worth really is.

The net present value of the company was soaring and could stand up to the
best companies out there, which was cool.