In a market economy, the property of any company has its value. It is formed by various cash flows. The organization, when established, regulates the authorized capital. This is the capital that the founders contributed to their enterprise. Further, after working for a year, the company can get a net profit, part of which is also used to finance activities. In addition, almost any organization uses credit funds.
All these cash flows flow into the organization so that it can fully function. All expenses associated with the movement of funds are taken into account when calculating net cash flow. But to assess each source, the weighted average cost of capital is determined as the sum of all the discounted components. The essence of the method and its principles are discussed below.
General principle of the technique
Weight average cost of capital (WACC) was first applied in 1958 by scientists such as Modigliani and Miller. The essence of their method is that the weighted average cost of capital is defined as the sum of the costs of a share of the company's funds.
To evaluate each financial source, it is discounted. This determines profitability, and then profitability. This is the minimum level of return to the investor that he receives from the use of his money in the activities of the company.
The company uses both its own and borrowed sources. Therefore, their specific gravity in the overall structure is studied in the research process.
The profitability of attracting certain funds makes it possible to estimate the weighted average cost of capital. The cash flow value is defined as the difference between revenues and expenses. The result is discounted.
Sources of financing
To understand the principle of the technique, it is necessary to understand the essence of things. All property of the company is reflected in the asset balance sheet of the organization. Where the company takes the funds to purchase materials and equipment from is presented in liabilities. First of all, this includes equity. This means assets of the founders of the company, as well as retained earnings.
The organization can finance its activities with borrowed funds. Each of the sources is different and has a certain weight.
This takes into account the weighted average cost of capital. An example of the calculation of the balance sheet structure of the liability can be as follows:
- 0.8 + 0.2 = 1, where 0.8 is the share of own resources, 0.2 is the number of loans.
This is the simplest principle of capital structure organization.
Calculation formula
To understand the technique, it is necessary to consider its principle in the form of a formula. If we represent the structure of the liability as the sum of borrowed and own resources, we get the simplest kind of model. The weighted average cost of capital, the calculation formula of which is applicable in this case, has the following form:
- WACC = Ssk * Dsk + Szk * Dzk, where Ssk and Szk - the cost of own, borrowed resources; Dzk, Dsk - the share of resources in the total balance sheet currency.
But in reality, this calculation is carried out after taxes. Therefore, the formula looks like this:
- WACC = Szk (1 - N) * Dzk + Ssk * Dsk, where N is the income tax rate.
This type of formula is used in the financial management process. The average cost of a company’s funds is not calculated informatively. Therefore, in the calculations, the share of each source in the structure must be taken into account.
Discount rate
The weighted average cost of capital is defined as the discounted amount of all sources that participate in the activities of the company. For the use of a particular type of resource you must pay. At the end of the reporting period, shareholders expect an appropriate share of net profit, and lenders expect dividends.
This value can be presented in monetary terms or in the form of a coefficient. The cost of capital is often presented in the form of interest. Depending on the liability article, determining the discount rate is more or less difficult.
In this case, for example, a bank loan does not cause difficulties. The discount rate is equal to interest on borrowed capital. Retained earnings and equity have the same value. The discount rate is equal to the required return on investment by shareholders.
Cost of own resources
By investing in company stocks, investors seek profit. At the end of the reporting period, it is distributed. At a meeting of shareholders, a decision is made on the appropriateness of allocating part of the net profit to the development of production. In some cases, it is completely distributed among shareholders.
The weighted average cost of capital is defined as the sum of the discounted shares of financial resources. The cost of borrowed funds can be determined in the process of obtaining them. Their profitability is easier to calculate.
But with internal resources, things are more complicated. Given the conditions prevailing in the capital market, stockholders require the return on their securities to be at least not less than the industry average.
Market price
During the analysis, the book value or market value of capital may be considered. If the organization does not have securities that are listed on the exchange, the weighted average cost of capital (the formula was presented earlier) is calculated according to the financial statements.
But having stocks, bonds that are traded on the market, it is necessary to take into account their quotes.
To do this, the number of all ordinary shares is multiplied by their market value. This allows you to estimate the real value on the day of the study. The same principle applies to bonds and other securities.
Calculation Example
To correctly understand the essence of the research methodology, it is necessary to consider an example of calculation. Financial managers, for example, found that the company attracted investments of 2.25 million rubles for its work. In the process of analysis, the weighted average cost of capital is calculated. The formula, an example of calculation by which will be presented later, uses a series of data.
The company had 1 million rubles of its sources. Their yield was 22%. A third-party investor provided the company 0.25 million rubles. with a rate of return of 20%. Two bank loans in the amount of 0.5 million rubles. were taken on conditions of payment of 16% and 17% per annum. According to these data, using the presented formula, the cost of financial sources is 17.57%.
If we did not take into account the share of each article in the balance sheet currency, the average would be 18.75%. This figure would be unreasonably high. Therefore, the weight of each share in the total indicator must be taken into account.
Investment Project Evaluation
Each investor seeks to invest his money in the most profitable project. This applies to both the founders and creditors of the company. To assess the appropriateness of financing a project, the weighted average cost of capital is used. The return on investment is defined as the difference between income and expense.
If it is 0, then the company does not suffer losses. But in this case, she does not receive income. This is the minimum level of profit that investors expect from the work of their capital.
To attract financial resources for full functioning, the organization must offer favorable conditions. If the company is unprofitable, it is even more profitable for the founders to invest their money in another project that is not related to the work of their company.
Tax shield
Since the fee for using borrowed funds refers to embezzlement, the effect of a tax shield appears. It is taken into account when calculating the weighted average cost of capital. WACC is defined as follows:
- WACC = Ssk * Dsk + Szk (1 - N) * Dzk.
Coefficient (1 - ) - this is the effect of the shield by which the share of investments will be reduced. In other words, if a company attracts borrowed funds at a constant level of equity, taxable profits will be less.
If you find the optimal value of borrowed sources of funds, you can increase the total profitability of the company.
Capital structure
As already clear, the optimal structure of the financial resources of the company allows you to observe the weighted average cost of capital (defined as the ratio of the share of each source of financing to the total cost).
Considering the cost of each source, as well as the size of the tax shield, analysts can determine at what amount of borrowed capital the profitability will be the highest. By properly organizing the structure of the liability, a company can maximize its market value.
This, in turn, opens up a host of new opportunities for the organization. The investment rating of the enterprise is growing. It becomes more profitable for capital owners to finance the activities of such an organization.
Legislation
According to regulatory documents in force in our country, the weighted average cost of capital is determined by the formula:
- WACC = Dsk (Ssk + 2%) + Dzk (Szk + 2%) * (1-H).
It should be noted that the cost of borrowed sources of financing should be determined as the average refinancing rate. It is established by the Central Bank of Russia. Data for the calculation is taken for 12 months. To determine the cost of equity, it is necessary to take into account the yield on liabilities of more than 12 months that the state has.
The calculation of the presented methodology is rather complicated. It is quite difficult to determine the cost of capital in an ever-changing market environment. However, this allows you to assess the real return on equity of the organization. The weighted average cost of capital is determined by both domestic and foreign companies.
Based on the analysis data, it is possible to choose the optimal structure of financial resources. At the same time, the growth of net profit increases the total cost of the organization and increases the investment rating. No more or less large company can do without calculating the presented indicator. On its basis, activity planning is carried out. Therefore, every analyst should apply and understand the presented methodology.