Components of the WACC
What are the components of the WACC? How is this rate used by a company? Provided at least 2 examples.
Further, what would cause a company to have a high/lower WACC? Does the type of industry influence the WACC? Provide some examples (at least 2) of factors that would contribute to a high WACC.
Sample Solution
The Weighted Average Cost of Capital (WACC) is a calculation used to estimate the overall cost of a company’s capital. It can be thought of as the required rate of return necessary for a business in order to make its investments worthwhile. WACC is typically comprised of three components: debt financing, equity financing and preferred stock financing. According to Investopedia (2020), “the WACC considers both the cost associated with each component as well as its relative weight in the organization’s capital structure”
Debt Financing – This component measures the weighted average cost of all debt such as bonds, loans or lines of credit that are used to finance operations and growth. The cost is usually determined by taking into account interest rates on these debts, fees paid when borrowing, and any other related expenses.
Equity Financing – This part measures the returns investors expect from their investment in common stock or retained earnings. As investing in stocks involves risk, companies have to pay a premium over what they would pay for debt funding; this is called the cost of equity. It generally takes into consideration dividends being paid out and factors such as risk assessment and expected return on investment from similar assets.
Preferred Stock Financing – Preferred stock represents an ownership stake in a company but does not confer voting rights like common stock does; it also pays out fixed dividend payments regularly regardless if profits are made or not (Investopedia 2020). The preferred stock component measures how much investors expect back when investing their money into this type of security amid risk considerations and income expectations from similar securities .
The WACC estimation provides companies with an indication regarding how much capital they need to raise while allowing them to compare different sources based upon their estimated costs, thereby influencing decisions on which source would be most beneficial at that particular time frame (Gitman & Zutter 2010). For example, if a company decides it needs additional funds for expansion, it may use WACC calculationsto determine whether borrowing more money through loans or issuing new stocks will be less costly overall given current market conditions (Gitman & Zutter 2010). Alternately, another example could include deciding whether internal cash flow should continue towards projects or instead deployed towards paying off existing debts at lower than expected rates due an earlier purchase agreement; depending on several factors such as inflation rates and tax breaks provided by certain governments amongst others , managers can use WACC estimations prior making decisions affecting long-term objectives (Gitman & Zutter 2007).
