Financial balance is very important. Because it directly affects the development of each business . In particular, it is impossible not to mention WACC, but it is still quite unfamiliar to many people. What is WACC ? What is the formula and how is it calculated? These are definitely questions that many people are looking for answers to. So let's discover the answer through the article below.
What is WACC?
What is WACC ? - WACC stands for Weighted Average Cost of Capital, which refers to the weighted average cost of capital. It is also understood as the index indicating the average cost of capital calculated by enterprises on the basis of the proportion of different types of capital used.
Types of corporate capital include: Equity, bonds, preferred shares, common stock, and other long-term liabilities. Depending on the cost of each type, there will be different formulas for calculating the discount rate. From there, the net present value of the business can be calculated.
What is WACC?
However, because the finance of a business is mainly divided into two large segments, debt and equity . So the average WACC to raise that amount should be prorated by each source.
WACC can be used as a tool to check the effectiveness of an investment. This measurement does not require too much detailed information. Based on WACC, investors will somewhat more accurately assess the data in the financial statements of any securities company .
What is the formula and how to calculate WACC?
Currently, the average cost of capital of the enterprise WACC will be calculated by the formula:
WACC = (E/V) * Re + (D/V) * Rd * (1-Tc)
Inside:
- Re is the cost of equity
- Rd is the cost of debt
- E is the market value of total equity
- D is the market value of the firm's total debt
- V is the total long-term capital of the enterprise
- Tc is corporate income tax
In the above formula, E/V are ratios that represent financial ratios based on equity . Meanwhile, the D/V ratio would represent a debt-based financial ratio.
In addition, “(E/V) * Re” represents the weighted value of the capital linked capital. And “(D/V) * Rd * (1-Tc)” represents the weighted value of debt-linked capital.
The purpose of the WACC index is to determine the cost of each firm's capital structure. Based on the capital, owner's debt and preferred stock that WACC has.
Therefore, each component will have a different cost for the business. From there, the business will need to pay periodic interest on the debt. Plus a fixed rate on the preferred stock price . As can be seen, the average cost of capital by separating the capital structure of the enterprise into different parts and calculating each part separately.
What is the significance of the WACC index?
The WACC index plays a very important role for businesses in all business fields. By calculating WACC, we can get an idea of how much it will cost a business for each dollar of funding.
In addition, WACC is also used as a discount rate, serving to calculate the present value of the cash flows arising. As a result, businesses will easily evaluate and choose suitable investment projects.
What is the meaning and role of the WACC indicator?
Besides, what is the importance of WACC? It is also used to evaluate the profitable investment opportunities of a business. Because it represents the opportunity cost of the business. WACC will act as the minimum rate of return. To help businesses evaluate mergers and acquisitions. As well as the financial model of insider investments .
Investors can often use WACC as a checking tool. Simply put, WACC is the minimum acceptable rate of return . There, a business brings profits to investors. How to determine personal return on investment in a business? We just need to subtract WACC from the profit percentage of the business.
Some disadvantages of the WACC . indicator
Although WACC plays an important role, there are also some limitations. So what are the limitations of WACC?
WACC only applies to small businesses or projects. For large projects, this will not be applicable. Because WACC can change business risks. Thereby making investors not see exactly the feasibility of the project.
For large projects, it will not be applicable
When receiving the financing of a new source of capital. But this source of capital creates a big change in the capital structure of the enterprise. The WACC index is also not applicable.
Summary
We have just compiled basic information about what is WACC ? As well as the formula and how to calculate WACC. In stock investing , WACC is often used to consider potential stocks to invest in. Hope the above sharing of ideas has partly helped you in the investment analysis process.
