# Tag Archives | weighted average cost of capital

Economic value added (EVA) measures the effects of managerial actions. It also focuses on managerial effectiveness in a given year.

Use the following formulas to calculate the EVA:

EVA = Operating profit after taxes – Cost of all capital

Or = (Sales revenue – operating costs –taxes) – (total capital supplied * cost of capital)

For example, a company has \$10,000 in operating profit, \$50,000 in debt and weighted average cost of capital of 10%. The economic value added calculation can be found below:

EVA = 10,000 – (50,000 * 10%) = 5,000

### Applications

EVA is an estimate of a company’s true economic profit for the year. But it differs substantially from accounting profit. It depends on both operating efficiency and balance sheet management. Furthermore, without operating efficiency, operating profits will be low. In addition, without efficient balance sheet management, there will be too many assets, hence too much capital. In conclusion, it results in higher-than necessary capital costs.

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# Discount Rate Definition

The discount rate definition, also known as hurdle rate, is a general term for any rate used in finding the present value of a future cash flow. In a discounted cash flow (DCF) model, estimate company value by discounting projected future cash flows at an interest rate. This interest rate is the discount rate which reflects the perceived riskiness of the cash flows.

## Discount Rate Explanation

Using discount rate, explained as the risk factor for a given investment, has many benefits. The purpose is to account for the loss of economic efficiency of an investor due to risk. Investors use this rate because it provides a way to account and compensate for their risk when choosing an investment. Furthermore, this provides, with each choice, a buffer to provide for the chance of failure in an investment over time as well as many investments over a portfolio. Though risk is somewhat of a sunk cost, still include it to add a real-world element to financial calculations. It is a measure used to prevent one from becoming “calculator rich” without actually increasing personal wealth.

In DCF model, there are two methods to get discount rate: weighted average cost of capital (WACC) and adjusted present value (APV). For WACC, calculate discount rate for leveraged equity using the capital asset pricing model (CAPM). Whereas for APV, all equity firms calculate the discount rate, present value, and all else.

The Discount Rate should be consistent with the cash flow being discounted. For cash flow to equity, use the cost of equity. For cash flow to firm, use the cost of capital.

## Discount Rate Formula

A succinct Discount Rate formula does not exist; however, it is included in the discounted cash flow analysis and is the result of studying the riskiness of the given type of investment. The two following formulas provide a discount rate:

First, there is the following Weighted Average Cost of Capital formula.

Weighted Average Cost of Capital (WACC) = E/V * Ce + D/V * Cd * (1-T)

Where:
E = Value of equity
D = Value of debt
Ce = Cost of equity
Cd = Cost of debt
V = D + E
T = Tax rate

Then, there is the following Adjusted Present Value formula.

Adjusted Present Value = NPV + PV of the impact of financing

Where:
NPV = Net Present Value
PV = Present Value

### Calculation

See the following calculation of WACC and APV.

For WACC:

WACC = \$10,000/\$20,000 * \$2,000 + \$10,000/\$20,000 * \$1,000 * (1-.3) = \$1,050,000

If:
E = \$10,000
D = \$10,000
Ce = \$2,000
Cd = \$1,000
V = \$20,000
T = 30%

For APV:

APV = \$1,000,000 + \$50,000 = \$1,050,000

If:
NPV = \$1,000,000
PV of the impact of financing = \$50,000

## Discount Rate Example

For example, Donna is an analyst for an entrepreneur. Where her boss is the visionary, Donna performs the calculations necessary to find whether a new venture is a good decision or not. She does not need a discount rate calculator because she has the skills to provide value above and beyond this. Donna is the right hand woman to the entrepreneur which she aspires to be. But she first needs to prove herself in the professional world.

Donna’s boss wants to know how much risk he has taken on his last venture. He would like, eventually, to find the discount rate business valuation to judge levels for performance and new ventures alike.

Donna’s boss gives Donna the financial information she needs for one venture. She finds the discount rate (risk) using the following equation:

WACC = \$10,000/\$20,000 * \$2,000 + \$10,000/\$20,000 * \$1,000 * (1-.3) = \$1,050,000

If:
E = \$10,000
D = \$10,000
Ce = \$2,000
Cd = \$1,000
V = \$20,000
T = 30%

Next, Donna’s boss has her find the discount rate for another venture that he is involved in. The results are below:

Adjusted Present Value = NPV + PV of the impact of financing

Where:
NPV = Net Present Value
PV = Present Value

Donna appreciates her experience with her employer. As a result, she is sure that with this experience she can find the path to mentor another just like her. 1

# Weighted Average Cost of Capital (WACC) Definition

The weighted average cost of capital (WACC) definition is the overall cost of capital for all funding sources in a company. Weighted average cost of capital is used as commonly in private businesses as it is in public businesses.

A company can raise its money from the following three sources: equity, debt, and preferred stock. The total cost of capital is defined as the weighted average of each of these costs.

## Weighted Average Cost of Capital Meaning

Weighted average cost of capital means an expression of the overall requited return on the company’s investment. It is useful for investors to see if projects or investments or purchases are worthwhile to undertake. This is equally as useful to see if the company can afford capital or to indicate which sources of capital will be more or less useful than others. It has also been explained as the minimum return a company can make to repay capital providers.

## WACC Formula

The most popular method to calculate cost of capital is through using the following Weighted Average Cost of Capital WACC formula.

WACC = Ke *(E/(D+E+PS)) + Kd*(D/(D+E+PS))*(1-T) + Kps*(PS/(D+E+PS))

Where:
Ke = cost of equity
Kd = cost of debt
Kps= cost of preferred stock
E = market value of equity
D = market value of debt
PS= market value of preferred stock
T = tax rate

Ke reflects the riskiness of the equity investment in the company. Then, Kd reflects the default risk of the company. Finally, Kps reflects its intermediate standing in terms of risk between debt and equity. The weights of each of these components reflect their market value proportions and measure how the existing company is financed.

### Weighted Average Cost of Capital Calculation

Weighted average cost of capital calculation, though sometimes complex, will yield very useful results.

For example, a company finances its business 70% from equity, 10% from preferred stock, and 20% from debt. Ke is 10%, Kd is 4%, and Kps is 5%. The tax rate is 30%. The required rate of return of this company according to the WACC is shown below:

(70% * 10%) + (20% * 4%) + (10% * 5%) = 8.3%

That means the required return on capital is 8.3%. So, a company pays 8.3% interest for every dollar it finances.

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## Weighted Average Cost of Capital Examples

For example, Tim is creating a web 2.0 startup business called Webco. Tim, an avid user of the web and recent college graduate, has quite a bit to learn. As a result, he relies off of his networking ability and mentors to receive much needed advice.

Tim has prepared a full business plan. He is now moving his company to the next level by beginning to find capital providers. He has an expected range of the returns each source of available capital will require. Now, Tim needs to use the weighted average cost of capital method to decide whether his company will be able to receive capital from certain providers.

### Example Results

After doing some research, Tim is prepared to make his calculation. His results are below:

Tim’s company is considering financing its business 70% from equity, 10% from preferred stock, and 20% from debt. Ke is 10%, Kd is 4%, and Kps is 5%. Then the tax rate is 30%.

(70% * 10%) + (20% * 4%) + (10% * 5%) = 8.3% = WACC

That means the required return on capital is 8.3%. So, a company pays 8.3% interest for every dollar it finances.

Tim’s company, according to his calculations, will not be able to create the returns required to work with the mix of capital which is listed above. He resolves to do more research and then come back at the problem with a new approach.

Overall, this satisfies Tim. Though he has not seen the results that he was looking for, he was able to avoid a costly mistake by creating a plan before he began. He has confidence that despite this setback his career has a bright future.

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# Capital Structure Management

A company’s capital structure refers to the combination of its various sources of funding. Most companies are funded by a mix of debt and equity, including some short-term debt, some long-term debt, a number of shares of common stock, and perhaps shares of preferred stock.

When determining a company’s cost of capital, weight the costs of each component of the capital structure in relation to the overall total amount. This calculates the company’s weighted average cost of capital (WACC). Then use the weighted average cost of capital to calculate the net present value (NPV) of capital budgeting for corporate projects. A lower WACC will yield a higher NPV, so achieving a lower WACC is always optimal. Refer to overseeing the capital structure as capital structure management.

## Capital Structure Strategy

Under stable market conditions, a company can compute its optimal mix of capital. A company’s optimal mix of capital is the combination of sources of capital that yields the lowest weighted average cost of capital.

For example, if a company is financed by a combination of low-cost debt and higher-cost equity, then the optimal mix of capital would be some combination involving less of the higher-cost equity and more of the low-cost debt. In conclusion, you can employ capital structure policy and capital structure strategy to achieve the optimal capital mix.

### Capital Structure – Optimal Mix Example

Let’s say, for example, a company could raise between 40% and 60% of its needed funds with debt costing 8%. It could raise up to 10% of its needed funds with preferred stock issuance that costs 7.8%. Then it can raise between 30% and 50% of its funds by issuing common stock equity at 12.33%. What capital structure policy should the company employ to achieve its optimal capital mix?

After analyzing the numbers, and due to certain limitations and restrictions outside the scope of this simple example, the company came up with three choices:

```           Debt      Preferred Stock     Common Stock      WACC
Mix 1:      40%            10%                50%         10.145%
Mix 2:      59%            10%                31%          9.322%
Mix 3:      60%            10%                30%         11.679%```

As you can see, the company would be better off choosing Mix 2, which has the lowest WACC: 9.322%. 