Tag Capital cost

(WACC) Weighted average cost of capital (ra)

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Weighted average cost of capital (WACC) (ra) is a very simple concept. Weighted average cost of capital (WACC) refers to the weighted cost of both debt and equity financing, according to the firm’s specific optimal mix of financing (debt and equity). Knowing the weighted average cost of capital (WACC) enables better decision making about proposed projects.

The formula for weighted average cost of capital (WACC) (ra) is as follows:

WACC=(wd*rd)+(we*re)+(ws*rn or rr)

Where:

wd = a weight for the long-term debt

we = a weight for the preferred stock

we = a weight for the common stock

rd = the cost of long-term debt

re = the cost of preferred stock

rn = the cost of new common stock

rr = the cost of retained earnings

All sources of capital and their weights must be taken into account.

Example

Project Omega was proposed with an expected return of 9% and the firm’s cost of capital for debt financing is 7% and cost of capital for equity financing is 12%. Further, the optimal mix of debt and equity of the firm is 40 percent of debt and 60 percent of equity. Then, the weighted average cost of capital (WACC) is calculated as follows:

weighted average cost of capital (WACC) = 7% * 0.40 + 12% * 0.60

2.8 + 7.2 = 10%

The weighted average cost of capital (WACC) is 10%.

Given the information above, the proposed project with expected return of 9% should be rejected as it is below the firm’s 10% weighted average cost of capital (WACC).

When making investment decisions, business must only choose projects that bring returns higher than the weighted average cost of capital (WACC).

Test yourself

Company ABC has the following sources of capital:

Long-term debt at 7% after-tax cost with weight of 35% in the capital structure.

Preferred stock at 9% after-tax cost with weight of 10% in the capital structure.

Common stock at 14% after-tax cost with weight of 55% in the capital structure.

REQUIRED: Find the weighted average cost of capital (WACC).

SOLUTION:

weighted average cost of capital (WACC) =7%*.35+9%*.10+14%*.55

WACC=2.45+.9+7.7

WACC=11.05%

Calculating weights

As per above, to calculate the weighted average cost of capital (WACC) we need to know the weight of each source of financing. When calculating weights, market values or book values can be used. Market values evaluate the proportion of capital at the market value and book values evaluate the proportion of capital at the book (accounting) value. It is better to use market values, as it is a more realistic value.

Further, when calculating weights, we can use either target or historical proportions. Target proportions refer to the optimal capital mix that a business would like to achieve. Historical proportion refers to the proportion based on the past. The target proportion is preferred.

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Weighted average cost of capital (WACC) is a VERY important concept to understand. It is one of the central concepts in business and finance. The basic idea of weighted average cost of capital (WACC) concept is that it shows us the expected average cost of funds in the long-term. Make sure you are comfortable with explanations and calculations of the weighted average cost of capital (WACC) before progressing to the next section.

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The Difference Between IRR and NPV

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This article answers two questions:

1 – What is important difference between IRR and NPV?

2 – Based on these differences and other considerations, which method is more popular and which method is theoretically superior?

What is important difference between IRR and NPV?

Net Present Value method assumes that cash inflows are reinvested at cost of capital, which is more realistic than assumption made in Internal Rate of Return method (IRR) that cash inflows are reinvested at IRR.

Based on these differences other considerations, which method is more popular and which method is theoretically superior?

Theoretically, it is advisable to use the Net Present Value method because it assumes that cash inflows are reinvested at cost of capital. However, in real life, the Internal Rate of Return method is more common because it considers the rate of return instead of dollar amount considered in the Net Present Value method and the former seems to be more intuitive to users of techniques. There are, however, ways to deal with shortcomings of Internal Rate of Return method and therefore IRR is still considered a sophisticated and reliable technique.

Internal Rate of Return method (IRR)

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Sophisticated capital budgeting techniques include Net present value method (NPV), Internal Rate of Return method (IRR), Profitability index (PI) and Equivalent Annual Annuity (EAA). Internal Rate of Return method (IRR) is discussed below.

Internal Rate of Return (IRR) is a widely used technique.

It is also very easy to utilize Internal Rate of Return with the help of a financial calculator. It is much more challenging to calculate it by hand. Again, as in utilizing the NPV method, it is important to first understand the logic behind the calculation.

In simple terms, the IRR is the rate of return that would equate NPV with zero. If IRR higher than cost of capital than project should be accepted and vice versa. If IRR at least equals cost of capital than we know that business will earn at least rate equal to its cost of capital on this particular project.

Below is shown how to calculate IRR using the financial calculator.

IRR for annuity is calculated as follows:

Initial investment, minus sign – CFi

Annual cash inflow – CFi1

Number of periods – second function Ni

Second function IRR

IRR for a mixed stream is calculated as follows:

Initial investment, minus sign – CFi

Put in each cash inflow separately following with CFi1, CFi2 etc

Second function IRR

Both NPV and IRR will show whether the project is acceptable. However, the ranking of specific acceptable projects may differ between two techniques.

Test yourself

ABC have an option to invest in project B. The initial investment for project B is $35,000. Operating cash inflows from project B expected to be $5,000 per year for 8 years. The cost of capital of ABC is 5%.

What is the Internal Rate of Return (IRR) for project B?

Find out if project B is acceptable based on IRR calculation.

Solution:

With the help of financial calculator, we can determine IRR of project B as follows:

CFio: -35,000

CFi1: 5,000 (annual operating cash inflow)

Second function Nj: 8 (8 years)

Second function IRR: calculate – 3.07

The IRR of project B is 3.07%. The cost of capital of ABC is 5%. Since IRR (3.07%) is below cost of capital (5%), the project is not acceptable.

Test yourself

ABC have an option to invest in project D. The initial investment is $300,000. The operation cash inflows are expected to be $100,000 at the end of year 1, $110,000 at the end of year 2 and $130,000 at the end of year 3. The cost of capital of ABC is 10%.

  1. Calculate IRR
  2. Recommend if based on IRR technique project D is acceptable.

Solution:

1. With the help of financial calculator, the calculation is as follows:

Clear calculator: second function followed by C ALL

CFo: -300,000

CF1: 100,000

CF2: 110,000

CF3: 130,000

Second function IRR: calculate – 6.24%

2. Since cost of capital of ABC is 10% and IRR is only 6.24% (less than cost of capital), based on IRR technique, project D is not acceptable.

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