1. The Weighted Average Cost of Capital (WACC)
In this video, you'll learn about the weighted average cost of capital, or WACC also known as Wack. Calculating WACC is essential for our NPV calculations among other things.
2. What is WACC?
You will use WACC to discount values just like you used the rate of inflation in previous exercises.
WACC is the cost of funding a business and is comprised of two parts: the cost of equity and the cost of debt.
Each cost is multiplied by the relative proportion of a company's funding that comes from either debt or equity.
Mathematically speaking, the weighted average cost of capital for a given company is equal to the weighted sum of the company's cost of equity and cost of debt, including the tax implications of debt financing.
The cost of equity is the required rate of return which investors expect for a given company, and the cost of debt is the weighted average interest rate for the company's outstanding debt.
3. Proportion of financing
The proportional financing weights for debt and equity can be calculated using these formulas.
To calculate the equity financing weight, you can divide the market value of a company's equity by the total market value of a company.
For the debt financing weight, you divide the market value of a firm's debt financing by the total market value of the company.
4. Calculating WACC
Here's an example of calculating WACC for a company with a 12% cost of debt and a 14% cost of equity. The company has raised 20% of it's capital via debt and 80% via equity financing. You can see the formula is a weighted sum, taking into account the tax-deduction of 35% for the debt financing component.
5. Discounting using WACC
Companies use WACC as a discount rate because any project they undertake should outperform the cost of undertaking that action, which is exactly what WACC is. WACC is normally much higher than inflation, meaning that most companies will seek return on investment greater than 2-3%, which is the typical inflation rate.
For example, to calculate the NPV of a project that produces $100 in cash flow every year for 5 years, first we construct a repeating array of cash flows using np dot repeat. Next, we pass that array of cash flows into NumPy's dot npv function, and we pass the WACC of 13% as the discount rate. The result is a net present value to the company of 397 dollars in present value terms.
6. Let's practice!
Time to put this into practice.