Currently, in market conditions, the property of any company can be valued through its value. On the one hand, this is the company's own property, which is formed through the authorized capital, net profit. On the other hand, almost any company uses borrowed funds (for example, from banks, from other persons, etc.)
All these sources collectively merge into the organization, allowing it to function in market conditions.
The developed concept of the cost of capital today is basic in economic theory. Its essence lies in the fact that the property of the company has a set value like any resource - this value should be taken into account in the process of functioning of the business entity, as well as when making investment decisions.
However, this concept is much wider than the calculation of the relative amount of cash payments to investors, it also characterizes the level of return on capital that was invested.
In shaping the market value of a company, the concept of capital structure plays an important role. It is here that they resort to the calculation of the WACC indicator . Thus, when optimizing the structure of property, it is possible to simultaneously minimize its weighted average cost and maximize the market value of the company. To this end, a whole system of interrelated criteria and methods has been developed.
In order to evaluate each source of capital, the weighted average cost of capital is estimated, which is defined as the sum of all the discounting components.
The weighted average cost of capital can be used to determine the profitability of the company, as well as to determine the break-even sales volume and a number of financial indicators, including in the stock market.
Various methods for calculating the weighted average cost of capital may well be used in practice, where it is necessary to make managerial decisions in a short time.
Capital: Characteristics
The term "capital" means the value that is advanced in production with plans for profit and dividends.
On the one hand, capital is the sum of share premium and retained earnings, which relates to the interests of the owners of the organization, shareholders' funds. On the other hand, this is the totality of all long-term financial sources of the company.
Under the cost of capital is understood the total amount of funds that must be paid for the use of a certain amount of financial resources. It is expressed as a percentage of this volume.
The economic meaning of the indicator “cost of capital”:
- for investors, this is the level of cost of capital, which shows the rate of return on it;
- for organizations, this is the unit costs necessary to attract and maintain financial resources.
The main factors that affect the cost of capital:
- general state of the financial environment;
- the state of the product market;
- average loan interest rate;
- availability of financial sources;
- profitability of the company;
- level of operational leverage;
- concentration of equity;
- operational risk;
- company industry features.
Appointment
Historically, the start of the use of the WACC concept dates back to 1958 and is associated with the name of such scientists as Modigliani and Miller. They argued that the concept of the weighted average cost of capital can be defined as the sum of the shares of the company. Moreover, each share of the source must be discounted.
They associated this indicator with the minimum threshold of profitability for the investor, which he receives as a result of investing his funds.
The studied indicator reflects the following points:
- a negative value of WACC means the effective work of the firm’s management, which indicates that the company makes economic profit;
- if the studied value is within the framework of the dynamics of return on assets between the value “0” and the industry average, then this situation indicates that the company's business is profitable, but not competitive;
- if the studied indicator is higher than the industry average return on assets, we can safely say about the loss-making business of the company.
The concept
The concept of the weighted average cost of capital is based on the following definitions:
- capital - property of the company, which can be put into circulation in order to attract profit;
- price - the value that is fixed during the sale of capital, expressed as a percentage.
WACC is the minimum capital return threshold that a company has invested. In fact, the meaning of this indicator is that the organization can make decisions on capital investment only when their level of profitability is higher or equal to the value of the average weighted cost.
Generalized calculation formula
The process of assessing the cost of capital takes place in several stages:
- definition of the main components - sources of capital formation;
- calculation of the price of each source;
- calculation of the weighted average price using the specific gravity of each element;
- structure optimization measures.
In this process, attention should be paid to the taxation factor, since the profit tax rate is taken into account in the calculations.
In a generalized version, the formula looks like this: WACC = Ʃ (Be * Ce) + (1-T) * Ʃ (Bd * Cd), where:
- Be - equity, share;
- Vd - borrowed capital, share;
- Ce is the cost of equity;
- SD - the cost of borrowed capital;
- T is the tax rate of return.
Indicator Features
We highlight the main features of the formula for calculating the indicator:
- The purpose of the formula for calculating the indicator is that it allows you to evaluate not the value of the indicator itself. The meaning of the indicator is to apply the calculated value in the form of a discount coefficient when investing in a project;
- The weighted average cost of capital is a fairly stable value and reflects the optimal current capital structure of the company;
- The correctness of WACC calculation is related to the inclusion of comparable indicators in the formula.
Using the indicator to evaluate investment projects
WACC is used as a discount rate for calculating the profitability of investment projects. In this case, the cost of equity is the profitability of alternative projects, since it is it that acts as an indicator, and the value of the benefit that was lost. Such calculations make it possible to accept various investment projects.
Consider a specific example when using the WACC formula.
Basic input data for calculations:
- project A profitability - 50%, risk 50%;
- project B profitability - 20%, risk 10%.
We calculate the profitability of project B from the profitability of project A: 50% - 20% = 30%.
We compare profitability calculations:
- by A: 30% * (1-0.5) = 15%;
- by B: 20% * (1-0.1) = 18%.
It turns out that, if we want to get a return of 15%, we risk half the capital invested in project B. On the other hand, when implementing low-risk projects, a return of 18% is guaranteed.
Above, we examined options for evaluating investments using the theory of opportunity costs.
WACC calculation
Consider the WACC calculation formula for an enterprise: WACC = (US * ) + ( * ), where:
- CSS - equity, share;
- CA - the cost of equity;
- UZ - borrowed capital share;
- TSZ - the price of borrowed capital.
In this case, the value of the CA can be estimated as follows: CA = PE / SC, where:
- PE - net profit of the company, thousand rubles .;
- SK - equity of the company, thousand rubles
The value of CZ can be estimated as follows: CZ = Prots / K * (1-Kn), where:
- Interest - the amount of accrued interest, thousand rubles;
- K - the amount of loans, thousand rubles .;
- Kn - the level of taxation.
The level of taxation is calculated by the formula: Kn = NP / BP, where:
- NP - income tax, thousand rubles;
- BP - profit before tax, thousand rubles
Balance calculation
Consider an example of a WACC balance calculation formula. For this purpose, the following steps must be completed:
- find the financial sources of the company and their costs;
- multiply the cost of long-term capital by a factor of 1 - the tax rate;
- determine the share of own and borrowed capital in the total amount of capital;
- calculate WACC.
A sample of the steps for calculating WACC (balance formula) is presented below in accordance with the table.
Total capital | Balance line | Amount, thousand rubles | Share% | Price before tax,% | Price after tax,% | Expenses, % |
Equity | Page 1300 | 4206 | 62 | 13,2 | 13,2 | 8.2 |
Long term loans | Page 1400 | 1000 | fifteen | 22 | 15.4 | 2,3 |
Short-term loans | Page 1500 | 1544 | 23 | 26 | 18.2 | 4.2 |
Total | - | 6750 | 100 | - | - | 14.7 |
WACC calculation examples
Consider an example of a WACC formula based on the following source data:
Income tax | 25,431 thousand rubles |
Retained earnings | 41048 thousand rubles |
Interest | 13450 thousand rubles |
Loans | 17 900 thousand rubles |
Net profit | 15617 thousand rubles |
Equity | 103,990 thousand rubles |
Equity, share | 0.4 |
Borrowed capital, share | 0.6 |
- Calculation of the level of taxation: Kn = 25431/41048 = 0.62.
- Calculation of the price of borrowed capital: TS = 13450/17900 * (1-0.62) = 0.29.
- Calculation of the price of equity: CA = 15617/103990 = 0.15.
- Calculation of the WACC value: WACC = 0.4 * 0.15 + 0.6 * 0.29 = 0.2317, or 23.17%. This indicator means that it is allowed to make investment decisions with a profitability level above 23.17% for the company, as this fact will bring positive results.
Consider the calculation of the cost of WACC on another example according to the table below.
Financial sources | Accounting estimate, thousand rubles | Share% | Price,% |
Shares (ordinary) | 25000 | 41.7 | 30,2 |
Shares (preferred) | 2500 | 4.2 | 28.7 |
Profit | 7500 | 12.5 | 35 |
Long term loan | 10,000 | 16.6 | 27.7 |
Short term loan | 15,000 | 25 | 16.5 |
Total | 60,000 | 100 | - |
The following is an example of a WACC calculation formula: WACC = 30.2% * 0.417 + 28.7% * 0.042 + 35% * 0.125 + 27.7% * 0.17 + 16.5% * 0.25 = 26.9% .
The calculation showed that the level of costs to maintain the economic potential of the company with the existing structure of the sources of funds of the enterprise is, according to the calculations, 26.9%. That is, the organization can make certain investment decisions, in which the level of profitability is not lower than 26.9%.
Therefore, in the analysis, the WACC indicator is often associated with the indicator of the internal rate of return of IRR. This connection is expressed in the following: if the IRR value is greater than the WACC value, then it makes sense to invest. If the IRR is less than WACC, then investing is impractical. In the case when the IRR is equal to WACC, the investment break-even.
Therefore, the WACC indicator is decisive in the study of the rationality of the structure of financing sources in the company.
WACC and Accounts Payable
Consider the WACC model according to the company payable formula.
The WACC value is estimated without a tax shield according to the formula: WACC = * + * - * , where:
- DS - the share of equity in total sources of financing;
- SP - the cost of raising equity capital;
- DZ - the share of borrowed funds in total sources of financing;
- GCC - weighted average rate of borrowing;
- DKZ - the share of net payables in sources of financing;
- VHC - net payables value.
Features of the indicator in our country
The calculation of the weighted average rate in our country has a certain feature: WACC = SKD * (SK + 2%) + ZKd * (ZK + 2%) * (1-T), where:
- SKD - share of equity,%;
- SK - equity,%;
- - the share of borrowed capital,%;
- - borrowed capital,%;
- T - tax rate,%.
The cost of borrowed funds is estimated as the average value of the refinancing rate in our country, which is set by the Central Bank. To calculate the average indicator, use a period of 12 months.