Blog 3 - WACC: Weighted Average Capital Cost
WACC is a price tag used to measure the financing cost of an enterprise. In short, it describes whether the cost of financing is high or low.
If an enterprise needs financing, there are two ways: one is to issue stocks, the other is to issue bonds. The stock part includes common stock and preferred stock. WACC is to use the weighted method to consider the weight of each capital structure, and finally reflect the overall financing cost of the enterprise.
2. Expected return: the so-called expected return of capital is the cost for an enterprise. Common stock, preferred stock and bond need to be calculated separately. Among them, the bond part has the function of tax shield and needs to deduct tax.
The Calculation of wacc:
The result calculated by WACC is a percentage; and the cost ratio or the expected return of investors. The higher the WACC, the higher the financing cost of the company; and vice versa.
2. Evaluation of existing projects: only when the expected rate of return of the existing projects is higher than that of WACC, can they continue to operate;
3. Generally, the cost of issuing bonds is lower than the cost of issuing shares. Enterprises can reduce WACC by increasing long-term debt and reducing equity capital.
However, the application of WACC is not limited to this. When acquiring a company, WACC is often used as the discount rate to discount future free cash flow to the company for pricing. WACC can also be applied to the project return valuation. The present value of the project profit is calculated by discounting the future cash flow, which is often referred to as NPV. In this kind of valuation, as a discount rate, WACC reflects not only the financing cost, but also the required rate of return expected by investors. The cost of capital for a company or a project is actually the return expected by shareholders and debt holders. In other words, WACC is the opportunity cost for investors to bear the risk of investment company.
If an enterprise needs financing, there are two ways: one is to issue stocks, the other is to issue bonds. The stock part includes common stock and preferred stock. WACC is to use the weighted method to consider the weight of each capital structure, and finally reflect the overall financing cost of the enterprise.
How to calculate? Two parts are needed:
1. Weight: the weight of each capital structure is the proportion of its market value and total investment.2. Expected return: the so-called expected return of capital is the cost for an enterprise. Common stock, preferred stock and bond need to be calculated separately. Among them, the bond part has the function of tax shield and needs to deduct tax.
The Calculation of wacc:
The result calculated by WACC is a percentage; and the cost ratio or the expected return of investors. The higher the WACC, the higher the financing cost of the company; and vice versa.
WACC plays an important role in enterprise project evaluation:
1. New investment opportunities for enterprises: only when the expected rate of return is higher than WACC, investment is needed;2. Evaluation of existing projects: only when the expected rate of return of the existing projects is higher than that of WACC, can they continue to operate;
3. Generally, the cost of issuing bonds is lower than the cost of issuing shares. Enterprises can reduce WACC by increasing long-term debt and reducing equity capital.
However, the application of WACC is not limited to this. When acquiring a company, WACC is often used as the discount rate to discount future free cash flow to the company for pricing. WACC can also be applied to the project return valuation. The present value of the project profit is calculated by discounting the future cash flow, which is often referred to as NPV. In this kind of valuation, as a discount rate, WACC reflects not only the financing cost, but also the required rate of return expected by investors. The cost of capital for a company or a project is actually the return expected by shareholders and debt holders. In other words, WACC is the opportunity cost for investors to bear the risk of investment company.
The author use the picture to help me how to calculate the WACC and also tell us the roles in companies which WACC play！
ReplyDeleteThe author provides clear explanation of the formula of WACC, and explains the importance of WACC to an enterprise.
ReplyDeleteThe author focuses on the problems that need to be paid attention to in the calculation of WACC, and explains the significance of WACC.
ReplyDeleteGood blog! The formula of WACC is very clear according to the picture. Every letter has the meaning! I think you can add an example.
ReplyDeleteGood author, good blog, it is very clear to explain the WACC. You also can use an example to explain the WACC or explain WACC in which situations has limitations.
ReplyDelete