What is WACC? How to calculate and what WACC means to businesses

Currently, WACC is widely used by many businesses as an effective support tool in the process of carrying out business activities. With the content of the article below, 1C Vietnam will provide specific information about what WACC is , how it is calculated and what it means to businesses.

1. What is WACC?

WACC stands for Weighted Average Cost of Capital, meaning the weighted average cost of capital. This is the average after-tax cost of capital for a business, calculated on all capital sources that the business mobilizes for production and business activities. These sources of capital include common stocks, preferred stocks, bonds and other forms of debt.

2. Meaning of the WACC index for businesses

Businesses need to calculate and monitor WACC regularly to ensure they are using capital effectively and can achieve business goals. Below are some meanings of the WACC index for businesses:

2.1. Understand the investment capital structure

WACC is an index that measures the average cost of capital of a business, calculated based on the proportion of equity capital and debt capital. Management can use WACC to:

• Evaluate the efficiency of capital use of a business: The lower the WACC, the more efficient the business is in using capital.
• Adjusting equity and loan structure: To optimize capital costs and minimize financial risks, businesses need to adjust their capital structure to suit each stage of development.

For example, a business that wants to reduce its WACC may issue more bonds than stocks. This increases the debt-to-equity ratio but the cost of debt is lower than the cost of equity, leading to a decrease in WACC. However, businesses also need to consider increased financial risks when using a lot of loan capital.

2.2. Support decision-making for new asset purchases

The WACC is a useful tool to help management make decisions about financing new investments. By comparing the costs of debt capital and equity capital, the board of directors can determine the optimal financing plan that both ensures profits for the business and does not increase the average cost of capital.

Financing new investments with debt or equity can have a significant impact on a business's profits and stock price. Therefore, the board of directors needs to carefully consider these factors before making a decision.

WACC average cost of capital is also used to evaluate the feasibility of mergers. A merger is considered reasonable when the rate of return is higher than the WACC of the entire enterprise.

2.3. Supports identification of business risks

A business's business risk increases when its ability to generate profits is lower than its cost of capital. WACC average cost of capital helps businesses evaluate their cost of capital compared to competitors.

A business with a WACC lower than the average of businesses in the same industry means that the business can create more value for stakeholders and the risk of not achieving the required profit is lower. Therefore, the lower the WACC, the more valuable the business is and the easier it is to make further investment decisions.

2.4. An indicator to signal financial health

WACC is an index used by investors and creditors to evaluate the attractiveness of a business. A high WACC is a sign that a business has a high cost of capital, making investing or lending less attractive. This may cause investors and creditors to look for other potential opportunities. Therefore, businesses need to closely monitor WACC to ensure that this index is at a reasonable level, thereby satisfying more investors and creditors.

3. How to calculate WACC

Besides the question of what WACC is , how to calculate this index is also an issue of concern to many businesses. The general formula to calculate WACC is as follows:

Note:

• When calculating the average cost of capital, the cost of capital of each separate funding source must be the after-tax cost of capital.
• The capital structure used is the optimal capital structure, usually determined according to the company's market price.
• For simplicity, one can use the capital structure according to book value, if the book value approximates the market value.

4. Example of WACC

A joint stock company has a total capital of 8 billion VND, formed from three main sources: loans, preferred shares and equity.

Loan capital accounts for 45%, equivalent to 3.6 billion VND. Preferred shares account for 2%, equivalent to 160 million VND. Equity accounts for 53%, equivalent to 4.24 billion VND. The above capital structure is considered optimal.

Next year, the company plans to mobilize an additional 2 billion VND of capital for investment. Capital mobilization will be carried out according to the current optimal capital structure, in which the expected profit to be reinvested is 1.06 billion VND.

According to calculations, the cost of using loan capital before tax is 10%/year, the cost of using preferred shares is 10.3%/year, the cost of using retained profits is 13.4%.

Because the corporate income tax rate is 25%, the after-tax cost of using loan capital is 10% x (1 - 25%) = 7.5%.

The company's average cost of capital for investment is calculated as follows:

WACC = (45% x 7.5%) + (2% x 10.3%) +(53% x 13.4%) = 10.55%

Conclusion: The company's average cost of capital for investment is 10.55%.

Above is detailed information to answer the question of what is WACC . This is an important index that helps businesses make effective investment and financial decisions, so companies need to regularly calculate and update WACC to ensure optimal capital costs. helps achieve the highest profit and value. To learn more useful information to support business management, don't forget to follow other articles on the 1C Vietnam website.