WACC or the weighted average cost is the weighted average rate of return demanded by capital providers. It is a common techniques used as the discount rate when evaluating the project of a firm. However, it is only suitable when the capital structure of the project is the same as the capital structure of the company.
Who are the capital providers?
Debtholders – bondholders/bank
Equityholders – Common shareholders
Special equity holdes – preferred shareholders
Why it is used?
When we are evaluating a project/investment we must determine whether it is profitable for the providers of capital. So if you were asked to invest in a project that generated a certain stream of cash flows, you might choose to use the interest you can achieve in a term deposit as your discount rate. Similarily, the market sets a required rate of return for equity holders and debt holders. For a firm it would only be appropriate to pursue a project that was profitable to equity holders and debtholders. WACC calculates this!
Formula:
WACC = (D/D+E)(rd)(1-Tc) + (E/D+E)(re)
rd= cost of debt
re= cost of equity
Tc= corporate tax rate
D= Debt
E= Equity
Example:
AGY ltd has $500million of equity and $200million of debt. The cost of debt is 6% and the cost of equity is 12%. Tax is 30%. What is the WACC of AGY ltd?
Answer:
WACC = D/V * rd (1 – Tc) + E/V * re
= 200/700 *0.06 * (1-0.3) + 500/700* 0.12
= 9.8%