ABSTRACT: weighted average cost of capital .When WACC is

ABSTRACT:

This paper talk about WACC
and usages of weighted average cost of capital

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.When WACC is used:

  When evaluating an investment decision, we
know that we need to compare to next investment available for a company. There are
always multiple options for investment and in this situation the company needs
to choose between two projects and in such a case the company needs to show the
discount rate to calculate the net present value (NPV).

For example: A company
can choose to increase their activity by doing more of the same. Such as adding
more cores in a factory. Company can decide to invest in a new machine that
could increase the productivity of the current workforce. In such situations,
company can use WACC to understand the weighted average cost of capital money
that has been invested in a company as it can be invested in a project or
buying machines and then company is expected to generate a return. As we know
that WACC is known as return of the company, it is a return that gets generated
and paid to all investors like shareholders, banks and other lenders but
lenders are considers as timely investors for life of the company. They will
get profit of their invested amount on percentage base, mostly it is 5% of
their investment and bank will get their profit in the form of interest.

  Weighted
average cost of capital is the average rate of return a company expects to
compensate all its different investors. The weights are the fraction of each
financing source in the company’s target capital structure

Formula for WACC:

                                        
WACC=E/V*Re +D/V*Rd*(1-Tc)

Re= Cost of equity

RD= Cost of debt

E= Market value of the
firm’s equity

D=Market value of the
firm’s debt

V= E + D

E/V= percentage of
financing i.e equity

D/V= percentage of
financing i.e debt

TC= corporate tax rate.

 When we are discussing about the (WACC) the
weighted average cost of all the firm’s capital there are two importance points

            The
firm finances with debt preferred stock and common equity the WACC is the weighted
average of different types of capital

           

Importance and use of
weighted average cost of capital

·        
Weight average cost of capital is used as
a financial tool for both investors and companies.

·        
It is important for a company to make
their investment decision by choosing one project out of two similar projects
on the bases of low risk

·        
WACC is used to find the economic value
and net present value of the company and it is equally important for investors
to find the value of the company.

Basically,
the WACC is appropriate for a project NPV only when the risk of the project is
equivalent to the risk of the company. The real option analysis gets the
discount rate right the problem is that risk- neutral valuation may then
generate a debate about risk neutral pricing per se our alternative is to apply
real-option valuation but use a dictated discount rate e.g. the WACC adjusted
for risk to produce a correct real option valuation and thereby avoid issues
with risk-neutral pricing. Our WACC calculation is marginally more complicated
than risk-neutral pricing, but that complexity is a small price to pay for
appeasing risk-neutral valuation disbelievers while retaining the real-option
method the WACC illustrates that the additional mathematical complexity is
minor and that the option valuation produced is identical to that produced by
risk neutral valuation

 

WACC
analysis can be looked at two angles the investor and the company. From company
point of view, it can be defined as the blend cost of capital which the company
has to pay for using the capital of both owners and debt holders. From
investors point of view, it is opportunity cost of their capital if the return
offered by the company is less than its WACC. It is destroying value thus the
investors may stop investment in the company.

WACC
is widely used for making investment decision to understand more about WACC
lets see two different ways projects.

Evaluation
of project with the same risk:

      When the new project is of similar risk
like existing projects of the company, it is an appropriate benchmark rate to
decide the acceptance or rejection of these projects for example a car
manufacturer wishes to expand its business and they want to establish a new
factory of same kind in different location. if we observe the company is
entering into new projects in its own industry we can assume the same kind or
risk and use WACC as a hurdle rate to decide whether it should enter into the
project or not.

 

Evaluation of project
with different Risk:

            WACC is an appropriate measure to be used to evaluate a
project provided two underlying assumptions are true. The assumption is same
risk and same capital. In this situation WACC can be used with certain modification
with certain modification with respect to the risk and target capital
structure. Risk – adjusted WACC adjusted present value this are the concepts to
circumvent the problems of WACC assumption.

Discount Rate in net
present value calculations:

Net
present value is widely used method of evaluating projects to determine the
profitability of investment WACC is used as discount rate or the hurdle rate
for NPV calculations. All the free cash flows and terminal values are
discounted using the WACC.

            Calculated Economic value added(EVA)

EVA is calculated by
deducting the cost of capital from the net profits of the company. In
calculating the EVA, WACC serves as the cost of capital of the company. This is
how WACC may also be called a measure of value creation.

Valuation of company:

            Any rational investor will invest time before investing
money in any company. The investor will try to find out the valuation of the
company. Based on the fundamentals the investor will project the future cash
flows a discount them using the WACC and divide the result by number of equity
shareholders. He will get the per-share value of the company. He can simply
compare this value and the current market price(CMP) of the company and decide
whether it is worth investment or not. If it is less than CMP, it is overpriced
if the value is $25 and CMP is 22 the investor will invest at 22 expecting the
prices to rise till 25 and vice versa.

To elaborate more about
weighted average cost of capital WACC it is also referred to as the static
trade off theory. The trade -off theory is between debt and equity and the
purpose is the determine the minimum weighted average cost of capital by
combining the optimum mix of debt and equity. This is due to the interest on
debt is tax deductible and equity is riskier to the holder. As we consider that
equity requires a higher cost to the issuer. The weighted average cost of
capital can be analyzed as a u -shaped curve in which X- axis is known as
debt-to-total assets ratio and Y- axis is the weighted average cost of capital.
in this weighted average our aim is to find the debt ratio that minimize the
WACC.  Initially using more debt (such as
20-30% of total assets) lowers the WACC because debt is cheaper than equity.
But excessive use of debt (such as 60-70%) raise the WACC because lenders will
require higher interest rates and the cost of equity will go up because of
additional risk. The optimal point may be 40-50% in which the lower cost of
debt is balanced off against the higher cost of equity without substantially
increasing the risk of the firm. Once this debt ratio is determined and the
WACC is computed it is intended to be the discount or hurdle rate for each and
every project being analyzed. Projects are not analyzed simply by the means of
financing that project for example if low cost debt is used to finance a new
generator the cost of debt is not the hurdle rate because the low- cost debt
would not be possible without concurrent presence of equity to balance the
capital structure.

Some errors of WACC due
to not following the definition. Fernandez (2004) shows as

·        
Using a wrong tax rate to calculate the
WACC. The correct tax rate that should be used every year is the T that relates
the ECF and the FCF in equation.

·        
Calculating the WACC using book value of
debt and equity. The appropriate values of debt and equity are those resulting
from the valuation E & D.

Wrong
risk free rate used for the valuation

         Using the historical average of the
risk-free rate

         Using the short-term government rate

Wrong
beta used for the valuation

          Using the historical industry beta,
or the average of the betas of similar companies

           Using the wrong formulae for
levering and un-levering the beta

Wrong
market risk premium used for the valuation.

       The required market risk premium is
equal to the historical equity premium.

        The required market risk premium is
equal to zero.

Wrong
calculation of WACC

        Wrong definition of WACC

         Debt to equity ratio used to calculate
the WACC is different than the debt to equity ratio resulting from the
valuation.

          Using discount rate lower than the
risk- free rate.

           Using the statutory tax rate,
instead of the effective tax rate of the levered company.

           Valuing all the different businesses
of diversified company using the same WACC

            Considering that WACC/ (1-t) is a
reasonable return for the stakeholders of the company.

           Using the wrong formula for the WACC
assuming a certain capital structure and deducting the outstanding debt from
the enterprise value

           Calculating the WACC assuming a
certain capital structure and deducting the outstanding debt from the
enterprise value

            Calculating the WACC using book values of
debt and equity.

There
are lot of errors and their effects that frim needs consider when calculate the
WACC. It cannot avoid all of those errors because the time is continuous
changing. Every data can become the past one every time. Company and the
analyst can only determine the exactly results of project when it happened.
Company can only reduce those things as much as possible.

 

 

 

 

 

 

 

 

References

Block, S. (2011). Does
the Weighted Average Cost of Capital Describe the Real-World Approach to the
Discount Rate?. Engineering Economist, 56(2), 170-180.
doi:10.1080/0013791X.2011.573618

Importance and Use of Weighted Average Cost of Capital (WACC)