Weighted Average Cost of Capital — Microsoft Excel
In this article, we will walk you through the fantastic journey of learning WACC in finance using excel and along with that we also covering the fundamental concept of WACC. As we break down it in a simple manner, The Weighted Average Cost of Capital of a company measures its overall
cost of capital from all sources like debt, common shares and preferred shares.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital (WACC) of a company measures its overall cost of capital from all sources, such as debt, common shares and preferred shares. Each sort of capital’s cost is multiplied by how much of the total capital it makes up. The WACC is the typical interest rate that a business anticipates paying to finance its assets.
When calculating WACC, the cost of each capital source, debt and equity is
multiplied by the relevant weight by market value and the results are added up to reach the result.
Cost of equity >WACC>Cost of debts to balance equity and debt.
If a business invests all amount as equity, it has higher investors’ risk.
If a company takes all amount as debt, it has a higher risk to bank.
WACC is the most preferred investment, as it has medium risk.
Ideally, the debt equity ratio should be less than 1.
If NPV >0 with WACC as discount rate (interest rate) and IRR > WACC, one can take the project in both situations.
WACC Formula:
WACC = (E/C x Re) + ((D/C x Rd) x (1 – T))
Where,
E: Equity of the firm’s.
D: Debts Taken.
C: Total Value of Capital equity plus debt.
Re: Expected cost of equity.
Rd: Rate of Interest of debt.
T: tax rate.
Let us understand this with various examples.
We need ₹150 lakh.
Option 1: 100% loan @ 12% interest
Option 2: 50% loan @ 12% interest and 50% equity @ 20% return
Option 3: 30% loan @ 12% interest, 20% bonds @ 11% interest, 35% equity @ 20%
return and 15% preferred Shares @ 15% return.
Assume that the tax rate is 30%.
As we can see in the above figure, Option 1 has a weightage average cost of 12% and Option 2 has 16%.
Option 3 has 13.31% weightage average cost of capital, which is calculated as follows.
WACC = WL*RL * (1-T) + WB*RB * (1-T)+ WE*RE + WP*RP.
Where,
WL: Percentage of Loan Taken.
RL: Interest Rate on Loan.
WB: Percentage of Bond.
RB: Interest of Bond.
WE: Percentage of Equity.
RE: Percentage of Return on
Equity.
WP: Percentage of Preferred Shares.
RP: Return on Preferred Shares.
T: Tax.
Conclusion
In this guide, we will covering the fundamentals of weightage average cost of capital in finance and along with that we also understanding how we calculate overall cost of all sources of a company and sometimes it is very useful for us, to measure the overall cash flows either, it inflow or outflow.
