The modern market economy contributes to the formation of the property value of any organization. This indicator is created under the influence of various cash flows. In the process of its activities, the company applies its own and borrowed capital. All these cash flows are poured into the funds of the organization, form its property.
WACC is a measure of the value of each individual source of funding for a company. This ensures the normal execution of technological cycles. Controlling the cost of capital sources allows you to increase profits. Therefore, this important coefficient is necessarily considered by analysts. The essence of the presented method will be considered below.
General information
Weighted Average Cost of Capital (WACC) is an indicator that analysts first began to consider in the middle of the last century. Such well-known economists as Miller and Modigliani introduced it. They proposed to consider the weighted average cost of capital. This indicator is still defined as the price of each share of the organization’s funds.
To assess each source of financing, discounting is performed. In this way, the level of profitability, and then the profitability of the business, is calculated. In this case, the minimum amount of payment to the investor for the use of his financial resources in the process of the organization is determined.
The scope of the WACC indicator for the company is determined when assessing the capital structure. Its cost is not the same for each category. That is why the price of each source of financing is determined separately. Profitability is also calculated for each individual category of capital. The difference between these indicators and the costs of attracting them allows you to determine the amount of cash flow. The result is discounted.
Financial sources
The cost of capital of WACC, examples and calculation formula of which will be presented later, requires an understanding of the organization of financing the activities of the company. The property controlled by the organization is represented on the active side of the balance sheet. The funds that formed these funds (raw materials, equipment, real estate, etc.) are indicated in the liability. These two sides of the balance are always equal. If this is not so, errors have been made in the financial statements.
First of all, the company uses its own sources. These funds are formed at the stage of creating the organization. In subsequent years of work, part of the profit (called retained) is attributed here.
Many companies use borrowed capital. In many cases this is advisable. In this case, the balance model may look like this:
0.9 + 0.1 = 1, where 0.9 is equity, 0.1 is credit.
Each category presented is considered separately, determining its cost. This allows you to optimize the balance structure.
Calculation
As already mentioned, WACC is an indicator of the average return on capital. To determine it, the generally accepted formula is used. In the simplest case, the calculation procedure has the following form:
WACC = * + * , where and - percentage indicator of the share of own and borrowed capital in the general structure, and - market value of own and credit resources.
To take into account income tax, it is necessary to supplement the above formula:
WACC = Ds * Ss (1-NP) + Dz * Sz, where NP - income tax.
This is the formula most often used by managers, analysts of the organization. Weighted average cost is an informative indicator, in contrast to the average price of capital.
Discounting
WACC indicator depends on the situation on the capital market. To be able to correlate the real state of affairs of the company with existing trends in the business environment, a discount rate is applied.
The use of each source to finance the work of the company is associated with certain costs. Dividends are paid to shareholders, and interest is paid to creditors. This indicator can be expressed as a coefficient or in cash. Most often, the cost of funding sources is presented as interest.
The cost of a bank loan, for example, will be determined by annual interest. This is the discount rate. For equity, this indicator will be equal to the required return expected by the owners of securities from the provision of their temporarily available funds for use by the company.
Cost of own sources
WACC is an indicator that takes into account primarily the cost of equity. Any organization has one. Shareholders buy securities by investing in the activities of their company. At the end of the reporting period, they want to make a profit. For this, part of the net profit after tax is distributed among the participants. Another part is directed to the development of production.
The more the company pays dividends, the higher the market value of its shares will be. However, without financing the funds for its own development, the organization runs the risk of falling behind its competitors in technological development. In this case, even high dividends will not increase the value of shares on the stock exchange. Therefore, it is important to determine the optimal amount of funding for all funds.
The cost of internal sources is difficult to determine. Discounting is carried out taking into account the expected return by shareholders. It should not be less than the industry average.
Aspects of Analysis
The cost of WACC capital should be considered in terms of market or balance sheet metrics. If the organization does not trade its shares in the stock market, the presented indicator will be calculated using the second method. For this, the data of financial statements are used.
If the organization forms its own capital through shares in free trade, it is necessary to consider the indicator in terms of its market value. For this, the analyst takes into account the results of the latest quotes. The number of all outstanding shares is multiplied by this indicator. This is the real price of securities.
The same principle applies to all components of an organization’s securities portfolio.
Example
To determine the value of the WACC indicator, it is necessary to consider the presented methodology as an example. Suppose a joint-stock company attracted financial sources for its work in the total amount of 3.45 million rubles. It is necessary to calculate the weighted average price of capital. For this, some more data will be taken into account.
Own financial sources in the company are determined in the amount of 2.5 million rubles. Their profitability (according to market quotes) is 20%.
The lender provided the company with its funds in the amount of 0.95 million rubles. The required rate of return on his investment is about 18%. When using the weighted average indicator, the cost of capital is 0.19%.
Investment project
WACC is an indicator that allows you to calculate the optimal capital structure for a company. Investors seek to invest their free funds in the most profitable projects with the least degree of risk. On the part of the company, financing its activities solely through its own resources increases stability. However, the organization loses the benefits of using additional sources. Therefore, some of the borrowed funds should be used by the company for stable development.
The investor evaluates the weighted average cost of the company's capital to determine the feasibility of the contribution. The company must provide the most acceptable conditions for the lender. If stability indicators have deteriorated over time, a large number of debts have accumulated, the investor will not agree to finance the activities of such an organization. Therefore, the choice of the optimal capital structure is an important stage in the strategic and current planning of any company.
All of the above allows us to conclude that WACC is an indicator of the weighted average cost of financial sources. On its basis, decisions are made on the organization of the capital structure. With the optimal ratio, you can significantly increase the profits of the owners and investors of the company.