Composite Cost of Capital: Everything You Need to Know
Composite cost of capital is a calculation of a company's cost of capital that involves the proportional weighting of each category of capital.3 min read
2. Breaking Down WACC
3. Uses of WACC
Composite cost of capital is also referred to as weighted average cost of capital (WACC). It is a calculation of a company's cost of capital that involves the proportional weighting of each category of capital. It takes into account all sources of capital, such as common and preferred stock, bonds, and other forms of long-term debt. Composite cost of capital can be used for a variety of purposes, from calculating economic value added to determining whether a certain investment is feasible.
How to Calculate Composite Cost of Capital
The WACC of a company increases when there is an increase in beta and return on equity, because higher WACC indicates lower valuation and greater risk. In order to determine WACC, you have to multiply the cost of each component of capital by its proportional weight and add up the results. The following formula elements should be included in the calculation of WACC:
- Re – The company's cost of equity.
- Rd – The company's cost of debt.
- E – Current market value of the company's equity.
- D – Current market value of the company's debt.
- V (E + D) – Current market value of the company's financing (equity plus debt).
- E/V – Percentage of the company's financing that is equity.
- D/V – Percentage of the company's financing that is debt.
- Tc – Corporate income tax rate.
Breaking Down WACC
Generally, a business finances its assets either with equity or through debt. WACC refers to the average cost of these forms of financing, each of which has to be weighted according to its proportionate use in a certain situation. By calculating WACC, you will be able to know the amount of interest your company owes for every dollar it finances.
Equity and debt are the two components that make up the capital funding of a company. Equity holders and lenders expect to receive returns on the capital or funds they have provided, which can be determined by calculating WACC. In other words, WACC indicates the opportunity cost involved when an investor decides to take on the risk of investing in a company.
WACC is a company's total required return. As such, the directors of a company will often use it to make decisions, such as determining the feasibility of mergers or other opportunities for expansion. WACC should be the discount rate that applies to cash flows with risk similar to that of the company.
To better understand WACC, think of a business organization as a pool of money. Money comes into the pool from two different sources: equity and debt. Proceeds from business activities are not regarded as a third source because the company keeps any leftover money that has not been distributed to its shareholders after paying off debt.
Uses of WACC
Securities analysts often use WACC to assess the value of investments and determine which ones they should pursue. For instance, in the analysis of discounted cash flow, WACC can be used as the discount rate for cash flows in the future to derive a company's net present value. In addition, it can be a hurdle rate against which businesses and investors can gauge return-on-invested-capital performance. It is also essential in the calculation of economic value added.
Investors frequently use WACC to determine whether an investment is worth pursuing. Basically, they see WACC as the minimum acceptable rate at which a business yields returns for its investors. In order to calculate an investor's returns on an investment, just subtract WACC from the business' returns percentage.
For instance, a company has a WACC of 11 percent and yields returns of 20 percent. This means it is yielding a 9 percent return on every dollar it invests, so it is creating $0.09 of value for every dollar spent. However, if the return is lower than WACC, it means the business is losing value.
Investors can use WACC as a reality check, but some of them may not want to go through the hassle of calculating it because it is a complicated process that requires a lot of information about a company. Nevertheless, if they decide to calculate WACC, they will have a better understanding of its significance in brokerage analysts' reports.
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