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# Weighted average cost of capital is defined as the average price of each source in the total amount (WACC)

In a market economy, the property of any company has its value. It is formed by various cash flows. The organization regulates the statutory fund at creation. This is the capital that the founders made to their enterprise. Further, after working for a year, the company can receive a net profit, part of which is also channeled to finance activities. In addition, almost any organization uses credit funds.

All these cash flows flow into the organization so that it can function fully. All costs associated with the movement of funds are taken into account when calculating the net cash flow. But for the valuation of each source, the weighted average cost of capital is defined as the sum of all discounted components. The essence of the method and its principles are discussed below.

## The general principle of the methodology

Weighted cost of capital (WACC) was first applied in 1958 by scientists such as Modigliani and Miller. The essence of their method is that the weighted average cost of capital is defined as the sum of the values of the company's share of funds.

To assess each financial source, it is discounted. This determines profitability, and then profitability. This is the minimum level of return to the investor, which he receives from the application of his funds in the company's activities.

The enterprise uses both own and borrowed sources. Therefore, their specific gravity in the overall structure is studied in the process of research.

The profitability of attracting these or other means allows us to estimate the weighted average cost of capital. The amount of cash flow is determined as the difference between income and expenditure. The result is discounted.

## Sources of financing

To understand the principle of methodology, it is necessary to understand the essence of things. All property of the company is reflected in the balance of the organization. From where the company takes funds for the purchase of materials and equipment, it is presented in the passive. First of all, it includes own capital. These are the funds, the property of the company's founders, as well as undistributed profits.

The organization can finance its activities and at the expense of borrowed funds. Each source costs differently and has a certain weight.

- 0,8 + 0,2 = 1, where 0,8 - the share of own resources, 0,2 - the number of loans.

This is the simplest principle of organizing the capital structure.

## Calculation formula

To understand the methodology, it is necessary to consider its principle in the form of a formula. If you represent the structure of liabilities as the amount of borrowed and own resources, you get the simplest kind of model. Weighted average cost of capital, the formula for calculating which is applicable in this case, is as follows:

- WACC = Сск * Дк + Сзк * Дзк, where Сск and Сзк - cost of own, extra resources; Dzk, Dsk - share of resources in the total balance currency.

But in reality, this calculation is carried out after the payment of taxes. So the formula looks like this:

- WACC = Сзк (1 - Н) * Дзк + Сск * Дск, where Н - the rate of the profit tax.

This type of formula is used in the financial management process. The average cost of the company's funds is not informative. Therefore, in the calculations, the share of each source in the structure is necessarily taken into account.

## Discount rate

Weighted average cost of capital is defined as the discounted amount of all sources that participate in the company's activities. For using this or that kind of resources it is necessary to pay. Shareholders expect a corresponding share of net profit at the end of the reporting period, and creditors - dividends.

This value can be represented in money equivalent or in the form of a coefficient. The cost of capital is often represented in the form of interest. Depending on the article of liability, it is difficult to determine the discount rate to a greater or lesser extent.

There are no difficulties in this, for example, a bank loan. The discount rate is equal to the interest for using borrowed capital. Undistributed profits and equity have the same value. The discount rate at the same time is equal to the return on investment required by shareholders.

## Cost of own resources

Investing their funds in the company's shares, investors are eager to make a profit. At the end of the reporting period, it is distributed. At the shareholders' meeting, a decision is made as to whether it is expedient to channel a portion of the net profit for the development of production. In some cases, it is distributed completely among shareholders.

Weighted average cost of capital is defined as the sum of discounted shares of financial resources. The cost of borrowed funds can be determined in the process of obtaining them. Their profitability is easier to calculate.

But with internal resources everything is more complicated. Given the conditions prevailing in the capital market, the owners of shares require the profitability of their securities at least not less than the average for the industry.

## Market price

In the process of analysis, the book or market value of capital may be considered. If the organization does not have securities that are quoted on the exchange, the weighted average cost of capital (the formula was presented earlier) is calculated according to the financial statements.

But having shares, bonds that are traded on the market, it is necessary to take into account their quotes.

## Example calculation

To properly understand the essence of the research methodology, it is necessary to consider an example of calculation. Financial managers, for example, have established that the enterprise attracted for its work an investment in the amount of 2.25 million rubles. In the process of analysis, the weighted average cost of capital is calculated. The formula, the calculation example for which will be presented below, applies a series of data.

Its sources were 1 million rubles. Their yield was 22%. A third-party investor provided the company with 0.25 million rubles. With a rate of return of 20%. Two loans of banks in the amount of 0.5 million rubles. Were taken on the terms of payment of 16% and 17% per annum. According to these data, using the formula presented, the cost of financial sources is 17.57%.

If you do not take into account the share of each item in the balance currency, the average would be 18.75%. This indicator would be unjustifiably overstated. Therefore, we must take into account the weight of each share in the overall indicator.

## Evaluation of the investment project

Each investor seeks to invest his money in the most profitable project. This applies to both the founders and creditors of the company. To assess the appropriateness of financing a particular project, the weighted average cost of capital is applied. The profitability of investment is defined as the difference between income and expenditure.

If it is equal to 0, then the company does not suffer losses. But in this case, she does not receive any income. This is the minimum level of profit that investors expect from their capital.

To attract financial resources for full-fledged functioning, the organization must offer favorable conditions. If the enterprise is unprofitable, it is even more advantageous for the founders to invest their money in another project that is not connected with the work of their company.

## Tax Shield

Since payment for the use of borrowed funds refers to embezzlement, the effect of a tax bill appears. It is taken into account when the weighted average cost of capital is calculated. WACC is defined as follows:

- WACC = Csk * Dsk + Csk (1 - H) * Dzk.

Coefficient (1 - H) - this is the effect of the shield, on which the share of investments will be reduced. In other words, if a company attracts borrowed funds with an unchanged level of its own capital, the taxable profit will be less.

If you find the optimal value of borrowed funds, you can increase the overall profitability of the company.

## Capital Structure

As it is already clear, the optimal structure of financial resources allows the company to observe the weighted average cost of capital (defined as the ratio of the share of each source of financing to the total cost).

Given the cost of each source, as well as the size of the tax bill, analysts can determine at what amount of borrowed capital the profitability will be the highest. With the right organization of the liability structure, the company can maximize its market value.

This, in turn, opens up a lot of new opportunities for the organization. The investment rating of the enterprise is growing. It is more profitable for the owners of capital to finance the activities of such an organization.

## Legislation

According to the regulatory documents in force on the territory of our country, the weighted average cost of capital is determined by the formula:

- WACC = Dsk (Cs + 2%) + Dzk (Csk + 2%) * (1-H).

At the same time, it should be noted that the cost of borrowed sources of financing should be defined as the average refinancing rate. It is established by the Central Bank of Russia. The data for calculation are taken for 12 months. To determine the cost of equity, it is necessary to take into account the yield of obligations for more than 12 months, which the state has.

Calculation of the presented methodology is rather complicated. Determine the cost of capital in a constantly changing market conditions is quite difficult. However, this allows us to assess the real profitability of the organization's capital. Weighted average cost of capital is determined by both domestic and foreign companies.

Based on the analysis data, you can choose the optimal structure of financial resources. The growth of net profit thus increases the total value of the organization, increases the investment rating. No more or less large company can not do without calculating the presented indicator. Based on this, activity planning is carried out. Therefore, every analyst should apply and understand the methodology presented.

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