Weighted Average Cost of Capital (WACC) is an overall rate of return that a company must achieve on its assets (e.g. Plant & Equipment, Goodwill, Cash, Buildings, Accounts Receivable), capital (common & preferred shares) & debt borrowed (bonds & notes payable, long term loans) in order to maintain or increase its current value of the stock. WACC is expressed in percentage format. For example, if a corporation has a WACC of 15%, this means it must operate its business in such a way that overall rate of return from all assets & business operations exceeds 15%. This enables the company to grow, use its assets in profitable ventures & grow its market share in its industry. A decreasing WACC indicates the company is having operational or efficiency problems, problems with its capital structure (too much debt or equity) & financing or other corporate finance issues that must be investigated and corrected.
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Large corporations such as Exxon Mobil or Johnson & Johnson need billions of dollars in Cash to finance their day to day business operations, make investments & acquisitions, pay income taxes, bonds payable and their workers’ salaries & other expenses. How do they raise funds to start up or continue their business? Companies can raise capital by either i) issuing bonds payable and ii) issuing common & preferred shares to investors.
What happens when a company does both of these? It issues bonds payable to investors who are looking for annual or semi-annual bond coupon payments (source of debt) versus more common & preferred shares (source of equity). This mix of bonds (debt) and common shares (equity) is known as a corporation’s Capital Structure. This mix of Capital Structure is important in how we calculate the weighted average cost of capital (see below).
Weighted Average Cost of Capital (WACC) Formula
The corporate finance formula for WACC is:
[By x D/C x (1-t)] + [Re x E/C]
By = Bond’s yield to Maturity (I/Y in BAII Plus Calculator)
D = Market Value (Present Value) of Bonds
(1 – t) = 1 – tax rate = Interest tax shield deductibility of interest expense
Re = Shareholder’s return requirement
C = Total value of all capital (Debt + Equity)’
i) Where does Capital come from?
1. Borrowing from banks (debt) and/or
2. Owners/Investors put their own money in to the company (equity).
ii) What is Cost of Debt?
Bank interest rate (%) charged to your company e.g. 5%.
iii) What is Cost of Equity?
– Expected % return of Owners/Investors
– Can use Capital Asset Pricing Model (CAPM) to compute this.
iv) So now, What is the Cost of Capital?
– Capital comes from D (debt) & E (Equity).
– Depends on where you got the money to start/run your company.
– If you got the money from bank borrowing (5%), then your Cost of Capital is 5%
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