WACC - is that the indicator? Concept, formula, example, use and criticism of the concept

To date, all companies in one way or another use borrowed resources. Thus, they function not only at their own expense, but also on credit. For using the latter, the company has to pay a percentage. And this means that the cost of equity is not equal to the discount rate. Therefore, we need another method. WACC is one of the most popular ways of evaluating investment projects. It allows you to take into account not only the interests of shareholders and creditors, but also taxes.

Example

So, we figured out that the WACC is an indicator of the average return on investment costs. But how to calculate it and where are the taxes? Suppose the company is funded by 60% at the expense of shareholders' money, 40% - by creditors. For example, it was estimated that the cost of equity should be 20%. A loan company managed to take at 15% per annum. If we approach the question of calculating the average weighted equity in terms of logic and mathematics, then we will get 18%. But is everything so simple? Suppose a company invested $ 1000 in the project under consideration: 60% - shareholders, 40% - creditors. If the duration of the project is one year, after the payment of taxes, the cash flow will be equal to 1180 dollars. USA. A thousand dollars is spent on the payment of the main investment. And the remaining $ 180. The US should be distributed among shareholders and creditors. The latter will receive 60 dollars. And then the fun begins. Interest payments can be deducted from the taxable base. Therefore, the company will be able to return some of the money. If the tax rate is 25%, then it is 15 dollars. And this means that the shareholders will receive not 120, but 135 dollars. USA. Therefore, we can conclude that the company could have earned less initially. And still it is impossible to satisfy the requests of both shareholders and creditors. It can not be said that WACC is an indicator of the average profitability of sales, since it deals with the result of the company's activity as a whole. But it was he who would allow a much more accurate calculation.

The concept of

As it was already possible to conclude from the given example, WACC is an indicator that allows to determine the profitability of the project necessary for creditors and investors. And he takes into account taxes. In the previous example, it is not 18%, but 16.5%. This is due to the existence of the effect of the "tax shield of credit financing". Suppose that the interest rate on the loan is 15%, as in the previous example. Then the actual cost of the loan is 15% * (1-tax rate in percent). The last one in our example is 25%. In this case, the company's loan will cost 11.25%. The WACC takes this into account.

Factors

Consider what affects the WACC. This is an indicator that characterizes the necessary profitability of an investment project. And it is influenced by external factors such as the situation on the stock market, the percentage of risk-free capital investments and the base rate of the market, as well as the profit tax. Companies have to work with them, trying to make the best use of available resources in the current situation. Important factors for management are factors such as the beta coefficient, the risk premium established at the enterprise, the ratio of borrowed capital to the total and the credit rating. Weighted average cost of capital is also affected by the following calculated indicators:

• Interest rate, cost and share of borrowed capital.
• Risk premium for the securities market.
• Cost and share capital.

Formula

First, we introduce the notation. Among them:

• E - cost of equity.
• RE - its necessary profitability.
• D - the cost of credit.
• RD - interest for using the loan.
• TR is the tax rate.

Thus, WACC = (E * RE) / (E + D) + (D * RD * (1-TR)) / (E + D). It should be noted that this formula takes into account only one type of loan financing. If our company uses several, then all of them need to be substituted separately with the appropriate rates.

Basic principles of borrowing

Companies benefit from financing from credit resources, if the interest for using the latter is low, since this reduces the company's average weighted cost of capital. However, the goal of any bank is not charity, but the execution of a profitable transaction. Therefore, more stable companies that have substantial collateral receive lower rates for taking a loan. Banks strive to get the fullest possible picture of their borrower, the qualifications of its top managers and staff, the company's track record and its business plan.

Criticism

WACC is a universally recognized tool for assessing the required return on investment projects. However, he has a number of significant problems:

• Availability of a "tax shield for credit financing". At first glance, it seems that the more loans, the better. And this really reflects the WACC. But how to take into account the increasing riskiness of projects with increasing their financing at the expense of creditors' money?
• Beta coefficient problem. This indicator should reflect the riskiness in comparison with the volatility of the assets of the entire market. Most often, companies from the S & P 500 list are used. However, many financiers do not agree with the fact that volatility is identical to risk. And this completely does not take into account the WACC.