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WACC Formula: The Basics of WACC And How It’s Calculated

This article will help you understand the WACC formula and how to calculate it. You'll be better equipped to make some important financial decisions in your future!

Weighted Average Cost of Capital formula is an important part of understanding the financing mix for a company.

Learn how the WACC formula works and how to calculate it.

WACC Formula and Definition

The WACC (Weighted Average Cost of Capital) is an important part of the capital structure and can determine a company’s financing mix such are, company’s various shares and its debt.

The WACC formula serves as a measurement tool for what a company should spend on debt and equity.

Calculating the WACC may sound complex, but it’s really not that difficult to do if you know how it’s done correctly.

It all starts with figuring out the cost of capital for each type of funding you’re considering, then plugging these numbers for calculating the WACC formula.  ( CFO Services for Startups in India )

What is the WACC Formula?

The WACC meaning is derived by dividing a company’s weighted average cost of debt (used for issuing debt) by its average earnings before interest, tax, depreciation and amortization (EBITDA), or EBITDA. EBITDA is considered the metric that determines whether or not a company is getting the most out of the revenue it generates.

EBITDA is the amount of money a company gets before it has to pay for the things that it purchases to produce or sell its products.

This is what allows companies to pay shareholders more in dividends than they could if they spent on major capital expenditures such as new facilities. When Calculating WACC the formula is often expressed as a percentage.

The weighted average cost of capital (WACC) is a measure of how expensive it is to borrow money or raise capital. WACC calculation looks at one part of the cost of equity capital and one part of the cost of debt capital.

wacc formula explaining

Weighted Average Cost of Capital

The higher the weighted average cost of capital, the higher the cost to borrow money. With the WACC formula, we can determine the cost of equity (what a company will actually pay per share for investment) and determine the cost of debt (how much it will pay per year for an investment). The WACC value is used to find out DCF of a company. ( Find more about dfc formula )

Cost of Debt

Debt capital is the money that a business borrows from a lender to finance its operations with an agreement that it must be paid back within an agreed-upon timeframe.

So, when you say Cost of Debt, this means you are talking about the interest rate applicable on borrowed money. You can say, this interest rate is also called the Cost of Debt.

The information must be available under your company’s balance sheet. When you have the details you can use the following formula to find out the cost of debt. (Interest rate) × (1-tax rate) / total debt Here; (1-tax rate) is used as a simple formula to get the post-tax value. Tip: You can use the formula 1 / (1-tax rate) to find out the pre-tax value.

Cost of Equity

Equity capital is an important element for any company.

It’s the money shareholders have invested in exchange for shares of stock and also the earnings they’ve reinvested. The cost of equity capital is the rate of return investors expect to receive if they invest in a particular company.

You can use CAPM (Capital asset pricing model) to calculate the cost of equity; Use this formula to calculate Cost of Equity= Risk-free rate of return + Beta × (market rate of return – the risk-free rate of return) Here; Beta is the measurement level of risk. Alternatively, you can also use the DDA method to find out the cost of equity.

DDA stands for Dividend Discount Model.  Cost of Equity = Dividend for all shares by next year projection ÷ Price of current stock  + Growth rate of the Dividend

How to calculate WACC (Weighted Average Cost of Capital)?

Now, as you are aware of the basic requirements, you are ready to fly it. Using the above value of the cost of debt and cost of equity you will be able to understand the Weighted Average Cost of Capital formula.

However, it takes time and practice to become good with it. WACC = {Interest expenses × (1-tax rate) / total debt}+ {risk free rate of return + beta × (market rate of return – risk free rate of return)}

Here; You could also use the DDA approach instead of using “CAMP” in WACC formula calculation.

 Can This Formula be Used for Taking Decisions?

The Weighted Average Cost of Capital or WACC is a key concept in business valuation, and assists with calculating your business’s Net Present Value. It is also a good method to assume investment opportunities by evaluating current market value in similar industries.

The weighted average cost of capital (WACC) is the rate a company pays on average to all its sources of financing. It is estimated by calculating and relating the cost of each type of financings, such as debentures, common stock, and preferred stock, by the percentage of total financing coming from that source.

So, what’s the bottom line?

The concept of WACC is important for business owners, who need to take financial decisions. Whether it’s the same or different risk project you’re evaluating, and economic value calculation or any of the concepts we’ve discussed so far.

What is The COST of Capital Meaning?

Let’s say you have $1 million of cash available and your starting cost of capital is 10%. Now let’s say you want to borrow $50 million to build a new building, and you decide to take the company’s existing debt and add additional equity.

You still want to calculate the cost of capital (without adding debt) so that you know how much to spend to build the new building.

Your original cost of capital is 10% (10% debt cost and 10% equity cost). So now you take the money out of the bank and add 10% ($50 million) to it to fund the building. Your cost of capital is now 20%.

Oh, that became a little hazy to understand that, Let’s understand that with the cost of capital definition instead;

The cost of capital is the reward you get for taking on a risky investment. Essentially, it’s the return you need to take on an investment.

Making it more simple to understand, you can remember this short sentence, in order to make a capital project, you need the right return!

You got this!

When analysts and investors talk about the cost of capital, they’re not talking about how much it costs you to buy a coffee.

They’re talking about the weighted average of a company’s, cost of debt, and cost of equity blended together.

Know More: Startup Valuation India

Nominal vs Real WACC

wacc formula
image: wacc

The difference between nominal and real free cash flows can be quite confusing. In order to calculate the correct discount rate, you need to know whether or not inflation is involved.

Every business structure has its own unique costs associated with its various financing methods. So, when you look at the WACC formula, you’ll need to understand its various components.

Nominal is most common in practice. Nominal WACC is the cost of equity in the worst-case scenario.

Before we get into the general definition, you should prepare to understand that in a more clear approach. Let’s understand the key points first.

Nominal Data: Nominal data is the simplest way to scale data. Nominal data can be analyzed using the grouping method, which allows for the grouping of variables into categories. The data can then be presented in many meaningful ways, such as a pie chart, visually represented graph, etc.

Inflation Data: Increase in prices of goods over a set period of time is referred to as the term Inflation. It can be seen as equivalent to a decrease in the value of the currency, which makes it difficult for people to maintain their standard of living. Source information; ipart (opens in new tab).

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