The weighted average cost of capital (wacc) is the average after-tax cost of different sources of capital of the company, including common stock, preferred stock, bonds and any other long-term debts. In other words, the wacc is the rate the company expects to pay on average to Finance its assets. As the company has two main sources of funding; debt and equity, wacc is the average cost of raising money.
The formula for SSK
The weighted average cost of capital is calculated by multiplying the cost of each source of capital (debt and equity) with corresponding weight and then add up the products to determine the wacc:
SSK = x re + x RD x (1 – TC)
- Re = cost of equity
- RD = cost of debt
- E = market value of the company
- D = market value of debt of the company
- V = E + D
- E/V = percentage of financing capital
- D/V = percentage of debt financing
- TC = corporate tax rate
Components of SSK
As noted previously, the company finances its assets either through debt or equity. Wacc is the average cost of these types of financing, each of which is measured at proportionate to use in a given situation.
The cost of equity represents the compensation the market demands in exchange for owning the asset and bears the risk of ownership.
The cost of debt means the effective rate a company pays on its current debt. In most cases, this refers to the after-tax cost of debt, but it also means that the cost of company debt to taxes. The difference in the cost of debt before and after taxes is that interest expenses are deductible.
To calculate the SSK, you need to determine how much of the company are financed through equity and how much debt. After what proportions of the total financing of the firm, which consists of debt and equity capital, multiplied by its appropriate value as shown below:
Steps to calculate the wacc
When calculating the weighted average cost of capital of the firm, the first step is to determine what proportion of the firm financed by equity and what portion is financed by debt
by entering suitable values and components of the equation. Further, the share of private capital () is multiplied by the cost of equity (re); and the share of debt () is multiplied by the cost of debt (RD).
The debt side of the equation (* d) is then multiplied by (1 – TC) to obtain the after-tax cost of debt (the tax shield associated with interest). The last step is to add the equity side of the equation in the debt side of the equation to determine the weighted average cost of capital.
For example, financial data of the company shows the following:
- Equity = $8,000
- Duty = 2,000 $
- Re = 12.5%
- RD = 6%
- Tax rate = 30%
To find the FCS, enter the values into the equation and solve:
SSK =[( x 0.125)] + [( * 0.06 * (1 – 0.3)]
SSK = 0.1 + .0084 = 0.1084, or 10.84%; the weighted average cost of capital of our company it is 10.84%.
SSK used in security, analysts and investors in assessing the value of investments and in determining which ones to pursue. Investors can often use the wacc as an indication of whether the investment is worth it. Simply put, the wacc is the minimum acceptable rate of return for which the company is inferior returns for its investors. To see how Fedewral reservie and treasuries the impact of SSK, please, read how interest rates affect the weighted average cost of capital?
To determine the investor yield investment in the company, just subtract the SSK from the company returns a percentage. For example, suppose a company gives a yield of 20% and weighted average cost of capital of 11%. This means that the company gives a 9% profit on every dollar of investment. In other words, for every dollar spent, the company creates nine cents of value. On the other hand, if you return the company less than SSK, the company loses value. If the company has a yield of 11% and wacc of 17%, the company is losing six cents for every dollar spent, indicating that potential investors will better put my money elsewhere.
FCS can serve as a useful reality for investors; however, the average investor will rarely get into trouble of calculating wacc because it is a complicated measure that requires much detailed company information. Since the calculation so involved, most investors use online analysis tools to find the company SSK. However, having the ability to calculate the wacc, which may help investors to understand wacc and its value when they see it in brokerage analysts ‘ reports. As a result, the understanding of wacc, which can help investors make more informed investment decisions.