Weighted Average Cost of CapitalAnalyzing Firms
The Weighted Average Cost of Capital is the interest rate of all financing that a company has acquired after it has been weighted and averaged. This benchmark sets the base rate of return for all projects that a company interacts with and is involved in. If a company is developing a project, campaign, or product, the results of the production must exceed the result of the WACC or the company is destroying value, since the capital it is using for the project costs more than it is returning. If the returns exceed the Weighted Average Cost of Capital, the firm is earning money at a higher rate of return than it costs them to acquire the money, and is earning a “profit” in comparison to the capital’s cost. This indicates the firm is increasing value since it is using its existing capital to grow faster than its cost. The higher a firm’s Weighted Average Cost of Capital, the higher the likeliness that the returns of projects will not exceed the cost of the capital to fund them. This in turn increases the likeliness that the firm will fail to meet its long term financial obligations. Weighted Average Cost of Capital helps to indicate the riskiness of a firm. The simplified formula for Weighted Average Cost of Capital is below:
(Market Value of Total Debt/Total Financing)*Cost of Debt*(1-Tax Rate)
+(Market Value of Equity/Total Financing)*Cost of Equity from CAPM
= Weighted Average Cost of Capital used for discount rate
The competed Formula for Weighted Average Cost of Capital is below. This formula is significantly more difficult to calculate and requires more research, but if executed correctly is significantly more accurate.
WACC = (MSRD/TF)*CD*(1-TR) + (MSBD/TF)*CD*(1-TR) + (MCE/TF)*CCE + (MPE/TF)*CPE
MSRD is the Market Value of Senior Debt determined by averaging Company Bonds.
MSBD is the Market Value of Subordinated Debt determined by averaging Company Bonds.
MCE is the Market Value of Common Equity.
MPE is the Market Value of Preferred Equity.
TF is the Total Financing, Sum of MSRD+MSBD+MCE+MPE.
CD is the Cost of Debt.
CCE is the Cost of Common Equity, Given by Capital Asset Pricing Model Estimations.
CPE is the Cost of Preferred Equity; Equals Preferred Stock Dividend divided by Current Price of Preferred Stock.
TR is the Tax Rate.
You can compare the Return on Invested Capital to the Weighted Average Cost of Capital to ensure that the firm you are investing in earns returns higher than its own obligations absorb. The difference between the WACC and the ROIC is the spread. If this spread is positive a firm’s ROIC will exceed its Weighted Average Cost of Capital. Higher positive spreads indicate greater likelihood the firm’s invested returns will exceed its cost of capital. The risk of being unable to meet its capital obligations will be low.
The cost of debt of a firm’s capital can be found by determining the yield to maturity of the firm’s debt: the yield to maturity of bonds from the firm. The yield is the interest rate payout, the cost of the capital, the firm is promising investors who purchase the bonds. The cost of capital must be determined from the current yield to maturity, and not the original coupon rate, which was set when the bond was introduced. The coupon yield is no longer reasonable since interest rates, market conditions, and bond prices change. Only the current yield to maturity is appropriate for determining the cost debt capital.
The Cost of Common Equity is typically derived from the Capital Asset Pricing Model (CAPM). This delivers an estimate of the rate of return that should be acquired from a certain level of risk. The capital asset pricing model delivers the rate of return that needs to be exceeded in order for the return to be worth the risk of investment. CAPM achieves this by comparing risk-free returns versus risky returns with a Beta. If the return of the investment is lower than the calculation with the Capital Asset Pricing Model, it is not optimal to invest in the asset. The equation for the Capital Asset Pricing Model is as follows: RF + BA*(RM-RF)
Where RF is the risk-free rate given by ultra-safe government bonds, BA is the Beta (either calculated or supplied typically by Morningstar or many other stock analysis firms), and RM is the expected (estimated) return of the asset on the market.
The Cost of Preferred Equity is equal to the perpetuity of the preferred stock. “Perpetuity” is an interest payment with an indefinite return. Preferred stock, which never matures but delivers an infinite series of dividends, qualifies as a perpetuity. In order to discover its cost of capital, you need to divide the Preferred Stock Dividend by the Current Price of Preferred Stock.
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