How To Calculate WACC
How To Calculate WACC
To start a business, you have to calculate all the necessary profits and loss to that business and after all the considerations, you may then invest in that business.
Hi. My name is Grant Hobson. I've been a finance analyst for the past six years.
Today, I'm going to run you through some finance performance methods as well as some investment appraisal techniques. How to calculate Weighted Average Cost of Capital, also known as WACC? The Weighted Average Cost of Capital seems when it raises finance, the cash raise is added in a pail of funds. This pail of funds involves equity, debt and then also preferential preference shares.
The idea of WACC is that we're trying to calculate how much the capital that we use for investment costs us. So we find investment ratios that we get back in return, a lot of percentage, then cost of capital, then it's not worth the investment project going ahead. However, if the investment project generates a percentage return which is higher than the cost of capital, then it makes sense to go ahead with the project.
Now, if a company which you're equity based, then the only consideration would be the returns the shareholder requires. So you can use a cup hand model which is when you come out with this, to calculate that, for example, your shareholders might want to return a 10%. Alternatively, you can just finance by debt and that would be your interest rate as charged by the bank, so maybe 6, 7%.
The weight average cost of capital assumes that we use this pail of funds which is combination of equity, debt and preference shares and then we generate an average cost of capital for these. The weighted element being that if we have 75% equity, 25% debt, then the rate that we use should reflect this weight in. So now to calculate the weight average cost of the capital, we need to first calculate the cost of equity, then we can calculate the cost of preference shares, and then we can calculate the cost of debt.
In this example, we shall use equity and debt to calculate the weight of the average cost of capital. So if we say the company's equity is 400, if we say that the debt is 300, we have a total capital of structure of 700 pounds. Now, just to calculate the WACC, what we need to do is we need to know the equity rate.
This is what could be calculated by using cup hand or alternatively if you're looking at this in a question, then it'll probably be provided. So, in this example, we'll take 16% as the rate, this is what or investors require a return of. For the debt, the 300 pounds will take a rate of 8% and this is what that bank charges in interest.
And also to take into consideration for the equity and also to take into consideration during the calculation as the Corporation Tax Rate which is at 35%. So what we do firstly is we'll calculate the debt level so this is far more simply 300 pounds of debt divided by the total 700. So this gives the portion of the debt in the total capital structure.
We then times this by the 8% rate. We then need to times this by 0.65.
0.65 represents that's 1 minus the 35% tax rate. So, 1 minus 0.
35 get to you 0.65 which gives us a value of 2%. If you do the equity part of the calculation, it follows the same method, so it's 400 which is your equity value divided by total value of 700, we times this by the rate that's required which is 16% which gives us 9% of requisite.
This is a portion the amount of debt and the amount of equity to get the WACC, we sum up the debt and the equity amount. So the weight average cost of capital in this example would be 11%. So what you do then is you consider this emulation to your investment calculations.
So if you've considered in your investment analysis and your appraisal will show you have a return greater than 11%, then it's a project that you should consider if it's less than the cost of your capital then you're making a loss considering the project. .