To date, all companies in one way or another use borrowed resources. Thus, they function not only at their own expense, but also credit. For using the latter, the company is forced to pay a percentage. And this means that the cost of equity is not equal to the discount rate. Therefore, another method is needed. WACC is one of the most popular ways to evaluate investment projects. It allows you to take into account not only the interests of shareholders and creditors, but also taxes.
Example
So, we figured out that WACC is an indicator of the average return on investment costs. But how to calculate it and where does the tax? Suppose a company is funded 60% from the money of shareholders, 40% from lenders. For example, it was estimated that the cost of equity should be 20%. And the company managed to get a loan at 15% per annum. If we approach the issue of calculating the weighted average equity in terms of logic and mathematics, then we get 18%. But is it that simple? Suppose a company invested $ 1,000 in this project: 60% - shareholders, 40% - creditors. If the duration of the project is one year, then after taxes, the cash flow will be equal to 1180 dollars. USA. A thousand dollars goes to pay the main investment. And the remaining 180 dollars. The United States should be distributed between shareholders and creditors. The latter will receive $ 60. And here the fun begins. Interest payments can be deducted from the tax base. Therefore, the company will be able to return some of the money. If the tax rate is 25%, then it is $ 15. And this means that shareholders will receive not 120, but 135 dollars. USA. Therefore, we can conclude that the company could earn less initially. And still it is impossible to satisfy the requests of both shareholders and creditors. This is not to say that WACC is an indicator of average sales profitability, since it deals with the result of the company as a whole. But it was he who would have made a much more accurate calculation.
The concept
As it was already possible to conclude from the above example, WACC is an indicator that allows you to determine the profitability of a project necessary for creditors and investors. Moreover, it takes into account taxes. In the previous example, it is not 18%, but 16.5%. This is due to the existence of the “tax credit financing shield” effect. Suppose the interest rate on a loan is 15%, as in the previous example. Then the actual cost of the loan is 15% * (1-percent tax rate). The last in our example is 25%. In this case, the company's loan will cost 11.25%. WACC takes this into account.
Factors
Consider what affects WACC. This is an indicator characterizing the necessary profitability of an investment project. And it is influenced by such external factors as the situation on the stock market, interest on risk-free capital investments and the base market rate, as well as income tax. The company has to work with them, trying to most successfully use its available resources in the current situation. Important factors for management are factors such as the beta coefficient, the risk premium established at the enterprise, the ratio of borrowed capital to total and credit rating. The weighted average cost of capital is also affected by the following calculated indicators:
- Interest rate, cost and leverage.
- Risk premium for the securities market.
- Cost and share of equity.
Formula
First, we introduce the conventions. Among them:
- E is the cost of equity.
- RE is its required return.
- D is the cost of credit funds.
- RD - interest on the loan.
- TR is the tax rate.
Thus, WACC = (E * RE) / (E + D) + (D * RD * (1-TR)) / (E + D). It should be noted that this formula takes into account only one type of loan financing. If our company uses several, then all of them must be substituted separately with the corresponding rates.
The basic principles of borrowing
Credit financing is beneficial for companies if the percentage for using the latter is low, as this reduces the weighted average cost of the company's capital. However, the goal of any bank is not charity at all, but the completion of a profitable transaction. Therefore, more stable companies that have substantial security receive lower interest rates on taking a loan. Banks seek to get the most complete picture of their borrower, the qualifications of their top managers and staff, the track record of the company and its business plan.
Criticism
WACC is a recognized tool for assessing the required return on investment projects. However, he has a number of significant problems:
- The presence of a "tax credit financing shield." At first glance, it seems that the more loans, the better. And that really reflects the WACC. But how to take into account the increasing riskiness of projects with an increase in their financing at the expense of creditors' money?
- Beta ratio problem. This indicator should reflect the riskiness in comparison with the volatility of the assets of the entire market. Most often, companies from the S&P 500 list are used. However, many financiers will not agree with the fact that volatility is identical to risk. And that completely disregards the WACC.