Weighted Average Cost of Capital (WACC): Forecasting Cash Flows

Every organisation requires financing to fund its operations. Weighted average cost of capital is the average cost that is required by a company for carrying out daily operations. It is quite similar to the required rate of return (RRR) as the WACC of a company is the amount that shareholders and investors seek as returns for their investment. One may take up an investment banking course to learn the fundamentals of WACC. 

It is a critical study that involves multiple parameters. The concept of Weighted Average Cost of Capital is of immense importance if one wants to build a career in investment banking.

Read on to improve your understanding of WACC. One may also consider signing up for an investment banking certification to enhance their knowledge.

What is the Weighted Average Cost of Capital (WACC)?

The Weighted Average Cost of Capital (WACC) represents a company's cost of capital by assigning a proportional weight to each category of capital. WACC is a form of after-tax cost of capital that includes numerous sources such as equity, preference shares, common stocks, bonds, borrowings etc. A banking course explains the concept of WACC in a detailed manner which helps professionals earn a good grasp of this topic.

WACC is the most commonly used and convenient way to calculate the required rate of return (RRR) since WACC reflects the amount of profit for the shareholders and bondholders in exchange for their investment in a single value. The WACC of a firm tends to rise as investors always want to extract higher returns on investment. However, this will only happen if the company includes volatile stocks or if the debt is regarded as unsafe and risky.

Understanding the WACC Concept

This concept is very important for companies to analyse various aspects and components of corporate finance. WACC is an immensely integral tool for the management of the company, investors and analysts. A banking and finance course will help professionals understand the intricate details of the Weighted Average Cost of Capital. 

WACC is commonly used as a benchmark rate by organisations and their investors to assess the economic worth of a specific initiative or purchase. Hence, this discount rate is commonly used by businesses to determine their net present value or to evaluate their discounted cash flow. WACC is also necessary in the case of a merger project when one company acquires the business and assets of another firm as it provides a clear picture in terms of a higher or lower cost of capital.

Also, a business's potential to increase its net profitability depends upon the WACC. It helps to maintain a balance between the company's assets and the borrowed funds.

Generally, a lower WACC represents a flourishing organisation that has the ability to draw the attention of investors at a reduced cost. On the contrary, a higher WACC frequently corresponds with businesses that are often perceived as risky and reward investors with more returns.

Formula and Calculation: WACC

The WACC formula considers both the equity and debt of the company for its calculation. There are various investment banking courses online that help to enhance the proficiency in the calculation of the professionals who pursue a career in banking and finance.

The following is the formula for calculating the Weighted Average Cost of Capital:

WACC= (E/V x Re) + {D/V x Rd x (1-Tc)}

Where,

E= market value of the company's equity

D= market value of the company's debt

V= E+D

Re= cost of equity

Rd= cost of debt

Tc = corporate tax rate

The value of WACC is determined by multiplying each source of capital that is equity and debt with the specific weights that are assigned to them. Then each of the values is added to get the definite product. In the above-mentioned formula, the financial capital based on equity is represented as E/V and the debt capital financing is denoted by D/V.

Hence, the calculation of the WACC is the result of the addition of these two sources of finance, represented as under:

(E/V x Re) - This portrays the weighted value of the equity capital.

{D/V x Rd x (1-Tc)} - This denotes the weighted value of the debt capital.

For instance, an organisation acquires INR 10 lakhs through debt financing and INR 40 lakhs via equity financing. Then the value of E/V will be 0.8. (Rs 40,00,000 ÷ Rs 50,00,000 of total capital). Similarly, the value of D/V will be 0.2. (Rs 10,00,000 ÷ Rs 50,00,000 of total capital). 

WACC in Forecasting Cash Flows

One of the major use cases of this formula and concept is to properly estimate and forecast cash flows in the future operations of a business. For forecasting cash flows, WACC is presented as a discount rate which is used to calculate the net present value (NVP) of an initiative, project or acquisition of the company. 

The difference between the present value of cash inflows and outflows is known as the net present value. The NVP presents an idea about the profitability of the acquisition or project undertaken by the company. WACC is an integral parameter for locating various investment opportunities and judging whether the investment will result in profit or loss. 

Hence, acquiring a deep understanding of the Weighted Average Cost of Capital is essential for individuals pursuing a career in investment banking as it enhances the skills of identifying potentially profitable areas of investment. This step is a key aspect of increasing an organisation's profitability while establishing a balance between equity and debt financing.

Conclusion

The significance of Weighted Average Cost of Capital (WACC) in the banking and finance industry is immeasurable. WACC is a very dynamic concept that has a variety of use cases, out of which, its usage in forecasting cash flows is the most notable one. 

If you are a banking and finance professional or want to start a career in finance, registering for an effective investment banker course can immensely help you gain the required knowledge.