ABSTRACT:

This paper talk about WACC

and usages of weighted average cost of capital

.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)