The life of an entrepreneur depends on their ability to make sound investment decisions. Sound investment decisions guarantee sustained profitability. Sustained profitability guarantees the attainment of the going concern status.
So a company that is in the business of long term investments must be armed with investment decision making tools that helps in figuring out the most profitable investment option. One of the most Important of these tools is the Weighted Average Cost of Capital (WACC). But first what is Cost of Capital?
Cost of Capital is what it will cost a company to secure funds (equity and debt). It is the required rate of returns on ordinary shares, preferred stock, debentures and so on. The cost of capital is the discount rate used in Net Present Value (NPV) calculations. It is also the rate for benchmarking calculated Internal Rate of Return (IRR),
It is the minimum return investors demand for making available the capital a new project requires.
The Weighted Average Cost of Capital (WACC) is used by analysts and investors to assess an investor’s returns on an investment. WACC is a very reliable method for estimating cost of capital,
Now, how is WACC (an investment appraisal technique) found?
WACC is arrived at, by determining the average of the costs of individual component of a company’s finances. This average is found by weighting the sources of finance by their corresponding share of the total collection of capital available.
For example if a company had the following portfolio of equity and debt>;
- 3 million $1 (face value) ordinary shares with a market value of $1 per share (available at par) and an estimated cost of 10 percent,
- 2 million $1 preference shares with a market value of $0.20 and an estimated cost of 8 percent and,
- 5 million Debentures with a market value of $0.80 per $100 nominal value and an estimated cost of 3 percent, the weighted average cost of capital would be ;
|Component||Market Value ($)||Proportion||Estimated Cost||Weighted Cost|
|Ordinary shares||3m * $1 = 3m||41%||10%||0,41 * 10% = 4.1%|
|Preference shares||2m * $0.2 = 0/4m||5%||9%||0.05 * 9% = 0,45%|
|Debentures||5m * $0.8 + 4m||54%||3%||0.54 * 3% = 1.62%|
The weighted average cost of capital (WACC) is 6.17 percent. Remember, the lower the WACC, the higher the value of investment.
Since WACC represents the expense of raising money to fund an investment, a WACC of 6 percent means that this company would have to pay their investors $0.06 for every $1 received. A 6% weighted average cost of capital is a good go-aheadinvestment indicator in many industries.
So, what advantages does WACC have over other investment decision making tools?
WACC has the following advantages;
- WACC is an investor’s confidence booster; An investor with the finance to invest is often faced with the fear of uncertainty about the future. So, attaining a high level of confidence is required to overcome this fear. Such confidence must come from facts and figures.
WACC is often used to generate facts and figures that give an investor the confidence to make an investment decision.
- WACC helps pick out the best among alternatives; The dilemma of many investors is knowing with near accuracy, the best option among competing investment opportunities,. WACC is the reliable investment appraisal technique that is often adopted to pick the most favorable investment option.
WACC tells an investor the option that is likely to generate the highest Return on Investment (ROI). This is achieved by comparing the WACCs of companies competing for funding.
- WACC is the minimum hurdle rate; Investors would most times want to know, the minimum hurdle rate of return that would guarantee a satisfactory ROI. WACC is usually useful in this regard. WACC is used by investors and companies to determine the Return On Capital Invested (ROIC).
- WACC is used for the valuation of a firm. Remember that WACC determines the cost of capital by having each category of capital (equity and debt) proportionately weighted. A decrease in a firm’s WACC indicates a decrease in risk and an increase in valuation.
- WACC is a good measure of risk. An investor’s attitude to risk is a key factor in investment decisions.
As an investment rule, the expected return from an investment is expected to be directly proportional to the risk involved. WACC helps an investor to measure the risk associated with available investment opportunities. The risk associated with an investment increases as the corresponding WACC increases.