## Weighted Average Cost of Capital (WACC)

- What is WACC?: The weighted average cost of capital (WACC) measures a company's total cost of capital, taking into account both equity and debt. It signifies the minimum return a company must earn on its investments to satisfy investors and creditors. The formula for WACC is:

**WACC= (E/V x Re) + [(D/V x Rd) X (1-T)]**.- E= Market Cap (Stock market value)
- V= Total Value of Capital (Equity + Debt)
- Re= Cost of equity (required rate of return)
- D= Market Value of Firm’s Debt
- V= Total Value of Capital (Equity + Debt)
- Rd= Cost of Debt (yield to maturity)
- T = Tax rate

- Capital Structure: Capital structure refers to the mix of debt and equity financing used by a company. The optimal capital structure minimizes the WACC, and a higher proportion of debt financing can potentially lead to a lower cost of capital due to the tax-deductibility of interest payments.
- Components of WACC:
- Cost of Equity (Re): This is the rate of return equity investors seek from an investment in a company. It is typically calculated using the Capital Asset Pricing Model (CAPM) as follows: CAPM = Risk Free Rate + (Beta x Market Risk Premium).
- Cost of Debt (Rd): This represents the effective interest rate a company pays on its debts, such as bonds and loans. The pretax cost of debt differs from the after-tax cost due to the tax-deductibility of interest expenses. It is calculated as follows: (Risk Free Rate of Return + Credit Spread) x (1 - Tax Rate)

- WACC in Financial Analysis: WACC is used in financial analysis and value investing to evaluate the profitability of an investment opportunity. This is done by comparing the return on investment to the WACC. Additionally, WACC is used in determining the present value of a company's future cash flows in a Discounted Cash Flow (DCF) model.
- Example Calculation: ABC Inc.'s WACC is 7.5%, calculated with a capital structure of 60% equity and 40% debt, a risk-free rate of 5%, a beta of 1.6, a cost of debt of 5%, a corporate tax rate of 25%, and a market return average of 8%. With this WACC, any investment opportunity with a return greater than 7.5% is considered profitable.

Understanding WACC is vital for value investors as it's a key metric used to determine a company's intrinsic value, thereby informing investment decisions.