Wacc Finance Example

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WACC Finance Example

WACC: A Finance Example

The Weighted Average Cost of Capital (WACC) is a crucial metric in finance used to determine a company’s cost of financing its assets. It represents the average rate of return a company must earn on its existing assets to satisfy its investors, including both debt and equity holders. Let’s illustrate this with an example.

Scenario: Calculating WACC for Hypothetical Corp

Imagine Hypothetical Corp. has the following capital structure:

  • Equity: $50 million market value
  • Debt: $30 million market value

Therefore, Hypothetical Corp.’s total capital is $80 million ($50 million + $30 million).

Now, let’s determine the cost of each component of capital:

  • Cost of Equity (Ke): Hypothetical Corp.’s equity investors require a 12% return. This can be determined through models like the Capital Asset Pricing Model (CAPM) or the Dividend Discount Model.
  • Cost of Debt (Kd): Hypothetical Corp. has bonds outstanding with a yield to maturity of 6%. This represents the pre-tax cost of debt. However, debt interest is tax-deductible, which lowers the effective cost.

Assume Hypothetical Corp.’s tax rate (T) is 25%.

Calculating the WACC

First, we need to calculate the weights of each capital component:

  • Weight of Equity (We): $50 million / $80 million = 0.625 or 62.5%
  • Weight of Debt (Wd): $30 million / $80 million = 0.375 or 37.5%

Next, we calculate the after-tax cost of debt:

  • After-tax Cost of Debt (Kd_after_tax): 6% * (1 – 25%) = 4.5%

Finally, we can calculate the WACC using the formula:

WACC = (We * Ke) + (Wd * Kd_after_tax)

Plugging in the values:

WACC = (0.625 * 12%) + (0.375 * 4.5%)

WACC = 7.5% + 1.6875%

WACC = 9.1875%

Therefore, Hypothetical Corp.’s WACC is approximately 9.19%.

Interpretation

This means that Hypothetical Corp. needs to earn a return of at least 9.19% on its investments to satisfy its investors. Any project expected to generate a return higher than 9.19% would generally be considered a worthwhile investment, as it would increase shareholder value. Projects with expected returns below 9.19% would generally be rejected.

Significance of WACC

WACC is used extensively in corporate finance for:

  • Investment decisions: Used as a hurdle rate for evaluating potential projects.
  • Valuation: Used to discount future cash flows to determine the present value of a company.
  • Performance evaluation: Used to assess whether a company is generating sufficient returns for its investors.

Understanding and accurately calculating WACC is essential for making sound financial decisions.

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