The formula to calculate WACC is:
\[ \text{WACC} = \left(\frac{E}{V} \times rE\right) + \left(\frac{D}{V} \times rD \times (1 - t)\right) \]
Where:
The Weighted Average Cost of Capital (WACC) is a metric used to assess the cost of capital for a company. It represents the average rate of return a company must generate to satisfy its investors and maintain its overall value.
WACC is calculated by considering the proportion of each source of capital (debt and equity) a company uses, along with their respective costs. The costs are determined by the interest rate on debt and the expected return on equity. By assigning weights to each source based on their percentage in the company’s capital structure, the WACC is derived.
WACC is an important metric as it helps evaluate the feasibility of investment projects and strategic decisions. It serves as a benchmark rate of return that a company needs to achieve to create value for its shareholders. If a project or investment generates a return higher than the WACC, it is considered profitable and adds value to the company. On the other hand, if the return is lower than the WACC, it may indicate that the investment is not generating enough value.
Comparing the WACC with the expected return on an investment or project helps assess its profitability and potential risks. It guides companies in allocating their available capital to projects that have the potential to generate returns higher than the WACC, maximizing shareholder value.
Let's assume the following:
Step 1: Calculate total value (\(V\)):
\[ V = E + D = 500,000 + 300,000 = 800,000 \]
Step 2: Calculate WACC:
\[ \text{WACC} = \left(\frac{500,000}{800,000} \times 0.08\right) + \left(\frac{300,000}{800,000} \times 0.05 \times (1 - 0.30)\right) \approx 6.5\% \]
Therefore, the WACC is approximately 6.5%.
