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Weighted Average Cost of Capital (WACC)

Prerequisites

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1. What is WACC?

Definition: Weighted Average Cost of Capital (WACC) is the average cost of all sources of finance used by a company, weighted by their respective proportions in the capital structure.

Purpose: WACC represents the overall minimum return the company must earn to satisfy all its investors.

2. WACC Formula

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3. How to Calculate Weights

3.1 Book Value Weights

Based on balance sheet values.

Formula:

Weight of Debt = Debt / Total Capital
Weight of Equity = Equity / Total Capital
Total Capital = Debt + Equity + Preference

3.2 Market Value Weights

Based on current market prices.

Formula:

Market Value of Equity = No. of Shares × Market Price per share
Market Value of Debt = No. of Debentures × Market Price per debenture

Which is Better? Market value weights are theoretically superior as they reflect current investor expectations.

4. Comprehensive Numerical Problem (Book Value Weights)

Problem: Calculate WACC using the following information:

SourceAmount (₹)Specific Cost
Equity5,00,00016%
10% Debentures3,00,0007% (after-tax)
12% Preference2,00,00012%

Solution:

Step 1: Calculate Total Capital

Total Capital = Equity + Debt + Preference
Total Capital = ₹5,00,000 + ₹3,00,000 + ₹2,00,000
Total Capital = ₹10,00,000

Step 2: Calculate Weights

We = Equity / Total Capital
We = ₹5,00,000 / ₹10,00,000 = 0.50 or 50%

Wd = Debt / Total Capital
Wd = ₹3,00,000 / ₹10,00,000 = 0.30 or 30%

Wp = Preference / Total Capital
Wp = ₹2,00,000 / ₹10,00,000 = 0.20 or 20%

Verification: 0.50 + 0.30 + 0.20 = 1.00 ✓

Step 3: Calculate WACC

WACC = (We × Ke) + (Wd × Kd) + (Wp × Kp)
WACC = (0.50 × 16%) + (0.30 × 7%) + (0.20 × 12%)
WACC = 8% + 2.1% + 2.4%
WACC = 12.5%

Answer: The Weighted Average Cost of Capital is 12.5%.

Interpretation: The company must earn at least 12.5% on its investments to satisfy all investors.

5. Numerical Problem with Market Value Weights

Problem: A company has the following capital structure:

  • 10,000 Equity Shares of ₹10 each, Market Price ₹50
  • 5,000 Debentures of ₹100 each, Market Price ₹95
  • Cost of Equity = 18%, After-tax Cost of Debt = 8%

Calculate WACC using market value weights.

Given:

Equity: 10,000 shares, Face Value ₹10, Market Price ₹50
Debt: 5,000 debentures, Face Value ₹100, Market Price ₹95
Ke = 18% = 0.18
Kd = 8% = 0.08

Solution:

Step 1: Calculate Market Values

Market Value of Equity = No. of Shares × Market Price
MVe = 10,000 × ₹50 = ₹5,00,000

Market Value of Debt = No. of Debentures × Market Price
MVd = 5,000 × ₹95 = ₹4,75,000

Step 2: Calculate Total Market Value

Total Market Value = MVe + MVd
Total Market Value = ₹5,00,000 + ₹4,75,000
Total Market Value = ₹9,75,000

Step 3: Calculate Weights

We = MVe / Total MV
We = ₹5,00,000 / ₹9,75,000 = 0.5128 or 51.28%

Wd = MVd / Total MV
Wd = ₹4,75,000 / ₹9,75,000 = 0.4872 or 48.72%

Verification: 51.28% + 48.72% = 100% ✓

Step 4: Calculate WACC

WACC = (We × Ke) + (Wd × Kd)
WACC = (0.5128 × 18%) + (0.4872 × 8%)
WACC = 9.23% + 3.90%
WACC = 13.13%

Answer: WACC using market value weights is 13.13%.

6. Applications of WACC

6.1 In Capital Budgeting

  • Used as discount rate in NPV calculations
  • Projects with Return > WACC are accepted

6.2 In Valuation

  • Used to discount Free Cash Flows to Firm (FCFF)
  • Enterprise Value = PV of future cash flows discounted at WACC

6.3 In Performance Measurement

  • Economic Value Added (EVA) = NOPAT - (WACC × Invested Capital)
  • Positive EVA means value creation

6.4 In Capital Structure Decisions

  • Aim: Minimize WACC
  • Lower WACC → Higher firm value

7. Factors Affecting WACC

  1. Capital Structure Mix: More debt (cheaper) can reduce WACC, but increases risk
  2. Cost of Individual Sources: If Ke or Kd increases, WACC increases
  3. Market Conditions: Bull/bear markets affect cost of equity
  4. Tax Rate: Higher tax reduces after-tax Kd, lowering WACC
  5. Business Risk: Higher risk increases both Ke and Kd

Exam Pattern Questions and Answers

Question 1: "Calculate WACC." (6 Marks)

Given:

Equity: ₹8,00,000, Ke = 20%
Debt: ₹4,00,000, After-tax Kd = 10%
Preference: ₹2,00,000, Kp = 14%

Solution:

Step 1: Total Capital = ₹8L + ₹4L + ₹2L = ₹14,00,000

Step 2: Weights

  • We = 8/14 = 0.5714
  • Wd = 4/14 = 0.2857
  • Wp = 2/14 = 0.1429

Step 3: WACC

= (0.5714 × 20%) + (0.2857 × 10%) + (0.1429 × 14%)
= 11.43% + 2.86% + 2.00%
= 16.29%

Answer: 16.29%

Question 2: "Why is WACC important in investment decisions?" (4 Marks)

Answer: WACC is crucial in investment decisions because:

  1. Minimum Required Return: It represents the minimum return a project must generate to compensate all providers of capital (equity, debt, preference).
  2. Discount Rate in NPV: WACC is used as the discount rate in Net Present Value calculations. Only projects with NPV > 0 (when discounted at WACC) are accepted.
  3. Hurdle Rate: Projects earning returns less than WACC destroy value and should be rejected, while those earning above WACC create value.
  4. Reflects Risk: WACC incorporates the risk of the business through the cost of equity and cost of debt, making it a risk-adjusted benchmark.

Summary

WACC Calculation Steps:

  1. Find specific costs (Kd, Ke, Kp)
  2. Calculate weights (Book or Market value)
  3. Apply formula: WACC = Σ(Weight × Cost)
  4. Interpret: Minimum required return

Key Points:

  • Market value weights > Book value weights (theoretically)
  • WACC is used as discount rate in NPV
  • Lower WACC = Higher firm value
  • Debt reduces WACC due to tax shield (but increases risk)

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