Lots of materials have been written on the meaning, application and calculation methods of the weighted average cost of capital. The purpose of this article is to summarize the basic concept of WACC and set out the standardized business calculation method of WACC as simply as possible.
In general, weight average cost of capital is the indicator, which is used in assessing the need to invest in various securities and projects, discounting the expected returns from investments and measuring the cost of capital. The weighted average cost of capital shows the minimum funds return of the enterprise on the capital invested, or its profitability, i.e. this is the total cost of capital, calculated as the sum of the return on equity and borrowed capital, weighted by their specific share in the capital structure. The economic meaning of the weighted average cost of capital is that the organization can make any decisions (including investment) if their level of profitability is not lower than the current value of the weighted average cost of capital indicator.
WACC in this context will be used as the discount rate to calculate the net present value (NPV). If the NPV of the project is positive, therefore, the project is not only self-sustainable, but it also makes a profit above the average for the company. You can calculate the internal rate of return (IRR), the threshold cost of financing above which the project is not effective, and compare it with the company's WACC. Ideally, the IRR rate should be much higher than the WACC.
The WACC formula is:
WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))
E = market value of the firm’s equity
D = market value of the firm’s debt
V = total value of capital (equity plus debt)
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on existing debt)
T = tax rate
Example of WACC calculation
For example, if you are considering a project of investing in agricultural project in China. So you need to make decision if it’s profitable and worth your investment, you need to calculate WACC of this project and then use it for NPV and IRR computation.
CPI of USA and China for 2019-2029 (Forecast of IMF)
Example of WACC calculation for agricultural project in China.
In next articles we will review other next steps in identification of ways to use WACC indicator. If you have any further questions, please contact us.
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