Weighted Average Cost of Capital (WACC) is used to assess the value of, and return on investment of corporate operations such as project management. Said differently, the weighted average cost of capital is used to assess cost, compare profit, and in asset allocation decisions. WACC is a calculation that serves as a financial management tool to more accurately determine the fiscal benefits of capital asset management. For investors, the weighted average cost of capital can be used to in financial analysis of a potential investment or in distinguishing between investment opportunities.
To illustrate how weighted average cost of capital is used, consider a small landscaping business called Lad’s Landscaping that wants to purchase a wood chipper using a combination of debt, and shareholder capital. The proceeds from the chipped wood should be profitable enough to cover the cost of the debt and equity. It should also be more profitable than available alternatives that meed the same demand for chipped wood.
The weighted average cost of capital, when used in conjunction with the Net Present Value (NPV) of future cash flows should yield a viable estimate of profit provided the future cash flow itself is accurate. Moreover, to understand how the weighted average cost of capital is used, the above example of Lad’s Landscaping can be expanded upon. If the cost of the Wood chipper is $750.00, debt financing is $300.00 at five percent and equity financing is $400.00 at twelve percent with the remainder paid in cash what is the weighted average cost of capital?
Weighted average means proportional averaged cost; since $300.00 in debt is used to finance the wood chipper and the total cost is $750.00 then, $300.00/$750.00 is 40 percent. Similarly the equity portion of the cost is 53 percent. Consequently, the weighted proportion for each is the percent of total cost divided by the total percent i.e. 40 percent / 95 percent equals a weighted 42.1 percent weighted proportion of debt multiplied by the cost of five percent which is 2.1 percent. Similarly, the proportional cost of equity is 6.69 percent making the total weighted average cost of debt and equity 8.79 percent.
Even though cash poses no immediate cost, there may also be opportunity costs associated with the use of cash. For example, what if the landscaping used the $50.00 to advertise instead? Would the return on advertising lead to a return on cost greater than had the $50.00 been used for the woodchipper? Since return on advertising would have to be correlated with before and after dependent and independent variables, unless similar data exists from a previous advertising campaign, the cost would be an estimate. Since corporations may deduct interest payments on debt, tax percentage may also be subtracted from the weighed average cost of debt i.e. 2.1 percent and are often used in WACC calculations by multiplying the resulting proportional cost percentage by 100 percent minus a tax percentage. Thus, 2.1 multiplied by 25 percent or .25 is 1.575 percent making the total cost after tax 8.265 percent.
In the above example, we know the weighted average cost of capital for the wood chipper is 8.265 percent which in and of itself is not as useful unless compared against revenue and other investment options. For example, if the projected average future cash flow from wood chipper services and rentals is $6000 per year how much does the wood chipper yield? This depends on how long the wood chipper is financed. If it is perpetual, the weighted average cost of capital can be used as an expense i.e. $6000.00 x 8.265 percent is $495.90 for $5,504.10 per year.
The above earnings estimate does not include overhead and additional company expenses making WACC somewhat limited unless it also adds additional costs after being calculated. Even so, if the same WACC calculation is used for another investment such as a snow plow, and future cash flow is accurate, then the two costs can be compared against projected revenue to distinguish between the financial benefits of the snow plough versus the wood chipper. Moreover, even if total cost on average goes up by purchasing a higher cost snow plough, total earnings for the landscaping company can rise despite a lower profit margin. Since higher earnings somewhat trump profit margin, the weighted average cost of capital can be used to see how much profit margin would shrink if the more expensive snow plough is purchased in addition to the wood chipper.
1. http://bit.ly/9azJx6 (Value Based Management)
2. http://bit.ly/926bUg (QFinance)