Weighted Average Cost Capital(WACC)- The Clinching point for a  Business

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For any business unit to start and work, capital is the starting point. The person(s) setting up the business entity cannot, by himself/themselves alone, provide the total capital required for the business entity. While he/they provides a part of the capital from his own funds, he secures the remaining part of the capital by borrowing from his friends, relatives and market. Such borrowings require payment of interest. The interest paid on the borrowings constitutes the cost of debt.

 

The part of the capital contributed by the promoters, or partners or shareholders of a business is called the equity, while the borrowings from other sources constitute debt. There are several types in borrowing like plain borrowing, debentures, deposits, short term borrowings, and several other types. Different types of borrowings require payment at different rates of interest. Equity and borrowings together constitute the capital of the business entity.

 

Since different types of borrowings require different rates of interest, it is difficult to work out a single figure for the cost of the debt. Average cost of debt is, therefore, calculated to arrive at such single figure. Again, different types of debt are made use of , by a business entity in different amounts. Various types of debt have various significant levels (weights) with regard to the capital. The weight of a particular type of debt influences cost of that particular debt of the capital structure. The cost of each element of the capital structure of a business entity calculated after taking into account its weight is called the weighted cost of that particular element of debt. The average of the weighted costs of all elements (both equity & debt) of the capital structure of a business entity is called the ‘Weighted Average Cost of Capital’ (WACC) of the entity.

The ‘Weighted Average Cost of Capital’ (WACC) for a business entity is given by the formula,

W= (D/ D+E). Cd + (E/ D+E). Ce (simplest form)

Where,

W= ‘Weighted Average Cost of Capital’ (WACC)

E= Equity

D=Debt

Cd =Cost of debt

Ce= Cost of equity,

Where the business entity borrows through different methods, individual debt elements will be factored into the formula to obtain WACC.

 

Significance

The WACC forms the base for determining the rate of interest at which a business entity can borrow funds in the market. If the promoters of the business choose to go for borrowings at higher rates of interest, they are choosing to go for a riskier business.WACC forms the benchmark for return on investment (ROI) by the business entity. Business would be profitable only if ROI is greater than WACC. WACC would form the basis for decisions relating to pricing of products/services by a business entity in such a way that ROI exceeds WACC. WACC and ROI , together decide whether a business activity is feasible. With a number of debt instruments being available in the market, WACC is quite flexible to be decided in a way that is comfortable for the business entity.

 

 

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