The two main sources from which a company can raise money are equity and debt. WACC is the average of the costs of these two sources of finance and gives each one the appropriate weighting. Using a weighted average cost of capital allows the firm to calculate the exact cost of financing any project.
There are five steps to calculate WACC. Firstly, we calculate market value of each of the firm's securities, secondly, we calculate the weight of each security as a proportion of the firm's total financing, then we determine the required rate of return on each security, after that we calculate the weighted average of these required returns and finally we do not forget to adjust it for taxes.
The Formula of WACC is as follows:
WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)] + ((P/V) * Rp)
In the formula, "V" is the market value of a company and it is the sum of the company's debt and equity (V=D+E) and if there is any, we have to consider the preferred stocks (P) as well. While calculating the value of the company, we must use the market value of each sources. "E/V", "D/V" and "P/V" are the proportion of common stock, debt and preferred stock respectively in capital structure
Cost of equity (Re) is the return which shareholders can get from a company for holding its equity. It comes in form of cash distribution of dividends and cash proceeds from the sale of stock. It can be calculated in two different ways. We should consider the circumstances to choose which way would be more reasonable to use. The first one is Capital Asset Pricing Model (CAPM) and the other one is Dividend Growth Model.
The formula of CAPM is "Cost of Equity= Rf+ Equity Beta * (E(Rm) - Rf)"
Rf is a risk free rate. Financial managers measure the risk-free rate of interest by the yield on Treasury bills(or government bond). Rf is the rate of return which investors can get from these risk free assets. Equity Beta is used to measure systematic risk of an asset relative to the average systematic risk. Risk free assets have beta which equals to 0. If the beta equals to 1, it shows that the stock has average systematic risk. If the beta is higher than one, it indicates more systematic risk than the average. In the formula, expected Return on the market index E(Rm) minus Risk free rate is called expected market risk premium. It suggets that investors can receive an extra rate of return from investing in company's equity rather than the risk free assets.
If the company is distributing dividends and if growth is constant we can also use the Dividend Growth Model. The formula is DIV1/P0 + g. P0 is the current stock price , DIV1 is the forecast dividend at the end of year and g is expected growth rate in dividends. This model has one disadvantage which is it will get you into trouble if you apply it firms with very high current rates of growth. Such growth cannot be sustained indefinitely.
Another input in WACC formula is cost of debt. Cost of debt is the expected rate of return by investors for lending money to the company. Cost of Debt= Borrowing Rate (1- Tax Rate). In order to calculate borrowing rate either we could find yield on company's existing debt or we could find the bond rating and use the yield of bonds with similar rating. It is not the same as coupon rate. If bonds are traded, we can simply look up their price but many bonds are not regularly traded so we should estimate the market's required rate of return by examinig the yield to maturity. In the formula tax rate is the Marginal corporate tax rate.
If the company has preferred equity, firstly, proportion of preferred equity to the company's value should be figured out (P/V) . After that we have to calculate the cost of preferred equity (Rp) which is the rate of return that investors required when they purchase the preferred shares of the company. Since preferred shareholders have fixed dividends which differs from the common shareholders, cost of preferred equity can be found by dividing fixed dividends by the trading price of preferred shares.
When we are calculating cost of a new investment, we should try to have the lowest WACC as much as possible because a company with a lower cost of capital can easily return profits to its share or equity holders. We can reduce the WACC by changing the proportion of debt or equity. In the dilemma of using equity or debt, we should consider the cost of debt and equity. Cost of equity is usually higher than cost of debt because equity is riskier than debt so shareholders require higher rate of return. Moreover, interest payments are tax-deductible which reduces the cost of debt effectively and lowers the WACC. So, If cost of debt is less than cost of equity, we can reduce WACC by inreasing percentage of debt in mix.
However, just looking interest rates are not enough. Risk must be considered as well. Systematic risk consists of two factors. One of them is Business Risk(Firm's operation) another is financial risk (using debt financing). if company increases its barrowing, lenders would demand a higher rate of interest on the debt and the risk of the common stock would also increase and shareholders would demand a higher return(implicit cost of debt).To conlcude we have to consider all these facts in the dilemma of using debt or equity.
Atty Gonenc Yay, LL.M