WACC (Weighted Average Cost of Capital) Formula and Definition | Learn With Finance Strategists

Finance Strategists
30 Aug 202103:10

Summary

TLDRThe video explains the concept of Weighted Average Cost of Capital (WACC), detailing how it represents the average financing cost for a company, which includes both debt and equity. It discusses the calculation of WACC using a formula that incorporates the costs associated with each financing source, emphasizing its role as a discount rate for future cash flows and its comparison with the Return on Invested Capital (ROIC). A higher WACC than ROIC signals a potential issue for investors, prompting companies to consider adjustments to their capital structure or risk profiles to improve financial performance.

Takeaways

  • ๐Ÿ˜€ WACC (Weighted Average Cost of Capital) reflects the calculated cost of a company's financing.
  • ๐Ÿ˜€ Companies typically have a capital structure that includes both debt (e.g., bonds) and equity (e.g., common stock).
  • ๐Ÿ˜€ Each source of financing has associated costs, which are weighted in WACC calculations according to their proportion in the capital structure.
  • ๐Ÿ˜€ For example, a company with 50% debt and 50% equity will calculate its WACC based on the average costs of both sources.
  • ๐Ÿ˜€ The formula for WACC includes the cost of equity and the cost of debt, adjusted for the corporate tax rate.
  • ๐Ÿ˜€ The cost of equity can be estimated using models like the Capital Asset Pricing Model (CAPM) or the Dividend Capitalization Model.
  • ๐Ÿ˜€ The total cost of debt accounts for the stated interest rate and the tax benefits from tax-deductible interest payments.
  • ๐Ÿ˜€ WACC is often used as a discount rate for valuing future cash flows and is the required return for new investments.
  • ๐Ÿ˜€ A higher WACC compared to Return on Invested Capital (ROIC) indicates that a company's cost of capital exceeds its return on that capital.
  • ๐Ÿ˜€ Companies with a high WACC may consider strategies to lower their equity costs or alter their capital structure to improve financial performance.

Q & A

  • What is the Weighted Average Cost of Capital (WACC)?

    -WACC is the calculated cost of a companyโ€™s financing, reflecting the average rate that a company is expected to pay to finance its assets.

  • How is WACC calculated?

    -WACC is calculated by weighting each source of capital proportionately to its percentage of the total capital structure and multiplying by the associated costs.

  • What components make up a companyโ€™s capital structure?

    -A companyโ€™s capital structure typically includes a mix of debt (like bonds) and equity (such as common stock).

  • What is an example of a company's capital structure?

    -For example, Half & Half has a capital structure of 50% debt and 50% equity.

  • What are the costs associated with debt and equity?

    -The average cost of debt is the interest rate on bonds, while the cost of equity can be estimated using the Capital Asset Pricing Model or Dividend Capitalization Model.

  • How does tax impact the cost of debt?

    -The total cost of debt is reduced by the tax benefit derived from interest payments being tax-deductible.

  • What role does WACC play in investment decisions?

    -WACC is often used as the discount rate for calculating the value of future cash flows and serves as the required return for investing in new projects.

  • What does a WACC higher than the Return on Invested Capital (ROIC) indicate?

    -A WACC higher than ROIC suggests that the cost of capital exceeds the return on that capital, which can be a warning sign for investors.

  • What actions can a company take if its WACC is too high?

    -A company may lower its cost of equity, alter its capital structure to include more debt, or renegotiate existing debt to reduce WACC.

  • Why is WACC referred to as the 'hurdle rate'?

    -WACC is considered the 'hurdle rate' because it represents the minimum return that a company must earn on its investments to satisfy its capital providers.

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Related Tags
WACCInvestment StrategyFinancial AnalysisCapital StructureCorporate FinanceDebt ManagementEquity FinancingRisk AssessmentCash FlowReturn on Investment