The Weighted Average Cost of Capital (WACC)

WACC What precisely do the terms “cost of capital” and “weighted average cost of capital” mean? To begin, note that it is possible to finance a firm entirely with common equity. However, most firms employ several types of capital, called capital components, with common and preferred stock, along with debt, being the three most frequently used types.

WACC If a firm’s only investors were common stockholders, then the cost of capital would be the required rate of return on equity. However, most firms employ different types of capital, and, due to differences in risk, these different securities have different required rates of return. The required rate of return on each capital component is called its component cost, and the cost of capital used to analyze capital budgeting decisions should be a weighted average of the various components’ cost which is called WACC or Weighted Average Cost of Capital.

WACC Components; Cost of Debt The first step in estimating the cost of debt is to determine the rate of return debt-holders require (r D ). We should note that the required return to debt-holders, r D, is not equal to the project’s cost of debt, because, since interest payments are deductible, the government in effect pays part of the total cost. As a result, the cost of debt to the firm is less that the rate of r D.

WACC Components; Cost of Debt In summary the cost of debt for the project (firm) is the after tax cost of debt. This is the cost of debt used to calculate WACC. After Tax Cost of Debt = Interest rate – Tax Savings

WACC Components; Cost of Common Stock Companies can raise common equity in two ways: (1) directly, by issuing new share, and (2) indirectly, by retaining earnings. If new share are issued, what rate of return must the company earn to satisfy the new stockholders. This rate is the expected rate of return by equity holders (r E ).

WACC WACC or Weighted Average Cost of Capital is the weighted average of the cost of different capital components.

Corporate Valuation and the Cost of Capital Sales Revenues Operating Costs And Taxes Required Investments In Operation Financing Decisions Interest Rates Firm Risk Market Risk FCF (Free Cash Flow) WACC (Weighted Average Cost of Capital) Value of The Firm (Project) Present Value (Value)

The Statement of Cash Flow (C/F) The Statement of Cash Flow tries to explain the reasons for the change in cash between balance sheet dates. According to FASB, the statements of Cash Flows should explain changes in cash and cash equivalents. Cash equivalents represent short term, highly liquid investments in which a firm has temporarily placed excess cash. In other words, the statement of cash flows is the term used to refer to flows of cash and cash equivalents.

The Statement of Cash Flow (C/F) The Statement of Cash Flows classifies the reasons for the changes in cash as operating, or investing, or financing activity. The changes in the cash and cash equivalents during a period could be result of operating, investing and financing activities which could have different impacts on the long run ability of the firm or project to provide cash.

Cash Flow from Operating (CFO) Selling goods and providing services are the most important ways for a financially healthy company to generate cash. Assessed over several years, the cash flow from operation indicates the extent to which operating activities generate more cash than they use. A firm can use the excess cash flow from operation to acquire buildings and equipments, pay dividends, retire long term debt, and conduct other investing and financing activities.

Cash Flow from Operating (CFO) Cash Flow from Operations (CFO) naturally includes cash collected for sales and cash spent to generate sales. This includes operating expenses such as salaries, rent and taxes. But notice two additional items that reduce CFO: Cash paid for inventory and interest paid on debt

Cash Flow from Investing (CFI) The next section of the Statement of Cash Flows shows the amount of cash flow from investing activities. The acquisition of non-current assets, particularly property, plant, and equipment, usually represents a major ongoing use of cash. A firm must replace such assets as they wear out, and it must acquire additional non-current assets if it is to grow. A firm obtains part of the cash needed to acquire non-current assets from sales of existing non-current assets. Such cash inflows seldom, however, cover the entire cost of new acquisition.

Cash Flow from Investing (CFI) Firms not experiencing rapid growth can usually finance capital expenditures with cash flow from operations. Firms growing rapidly must often borrow fund or issue common stock to finance their acquisitions of non-current assets.

Cash Flow from Financing (CFF) At last, a firm obtains cash from short and long term borrowing and from issues of common or preferred stock. It uses cash to pay dividends to shareholders, to repay short or long term borrowing, and to reacquire shares of outstanding common or preferred stock. These amounts appear as cash flow from financing activities in the statement of cash flows.

Free Cash Flow (FCF) Business terminology refers to an excess of cash flow from operations over cash flow investing as free cash flow (FCF). Firms can use free cash flow to repay borrowing, pay a dividend, repurchase common stock, and add to cash on the balance sheet. Free Cash Flow is the sum of Cash Flow from Operating and Cash Flow from Investing. FCF = CFO + CFI

The Statement of Cash Flows (C/F) Cash Flow From Financing (CFF) Cash Flow From Operating (CFO) Cash Flow From Investing (CFI)

Free Cash Flow (FCF) Cash Flow From Operating Cash Flow From Financing Free Cash Flow (FCF)