If you have used the calculator for your stock valuation, you will notice there is this entry known as the Company WACC (%). So what is this company's WACC? WACC is actually an acronym for Weighted Average Cost of Capital for that company. If you understand about the capital budgeting process of a company that involved the discounted cash flow analysis, this is actually the discount rate that company used to discount its future cash flow. This rate is also known as the marginal cost of capital.
On the right (liability) side of a firm's balance sheet, we have debt, preferred stock, and common equity. These are normally referred to as the capital components of the firm. Any increase in a firm's total assets will have to be financed through an increase in at least one of these capital accounts. The cost of each of these components is called the component cost of capital.
The WACC is given by:
WACC = (wd)(kd)(1 – t) + (wps)(kps) + (wce)(kce)
where:
- wd = The percentage of debt in the capital structure
- wps = The percentage of preferred stock in the capital structure
- wce = The percentage of common stock in the capital structure
- kd = The rate at which the firm can issue new debt. This is the yield to maturity on existing debt. This is also called the before-tax component cost of debt.
- kd(l - t) = The after-tax cost of debt. Here , t is the firm's marginal tax rate. The after-tax component cost of debt, kd(l - t), is used to calculate the WACC.
- kps = The cost of preferred stock.
- kce = The cost of common equity. It is the required rate of return on common stock and is generally difficult to estimate.
How a company raises capital and how they budget or invest it is considered independently. Most companies have separate departments for the two tasks. The financing department is responsible for keeping costs low and using a balance of funding sources: common equity, preferred stock, and debt. Generally, it is necessary to raise each type of capital in large sums. The large sums may temporarily overweight the most recently issued capital, but in the long run, the firm will adhere to target weights. Because of these and other financing considerations, each investment decision must be made assuming a WACC which includes each of the different sources of capital and is based on the long-run target weights. A company creates value by producing a return on assets that is higher than the required rate return on the capital needed to fund those assets.
The WACC as we have described it is the cost of financing firm assets. We can view this cost as an opportunity cost. Consider how a company could reduce its costs if it found a way to produce its output using fewer assets, say less working capital. If we need less working capital, we can use the funds freed up to buy back our debt and equity securities in a mix that just matches our target capital structure. Our after-tax savings would be the WACC based on our target capital structure, times the total value of the securities that are no longer outstanding.
For these reasons , any time we are considering a project that requires expenditures, comparing the return on those expenditures to the WACC is the appropriate way to determine whether undertaking that project will increase the value of the firm. This is the essence of the capital budgeting decision. Since a firm's WACC reflects the average risk of the projects that make up the firm , it is not appropriate for evaluating all new projects. It should be adjusted upward for projects with greater-than-average risk and downward for projects with less-than average risk.
The weights in the calculation of WACC should be based on the firm’s target capital structure. In the absence of any explicit information about a firm’s target capital structure from the firm itself, an analyst may simply use the firm’s current capital structure as the best indication of its target capital structure. If there has been a noticeable trend in the firm’s capital structure, the analyst may want to incorporate this trend into his estimate of the firm’s target capital structure.
Alternatively, an analyst may wish to use the industry average capital structure as the target capital structure for a firm under analysis.
