WACC helps the investors decide whether to invest in a particular company or not. It shows the minimum rate at which the investors will earn on their investment. It is the income or value addition that the investors will earn at that specified rate. If the company’s rate of return is higher than WACC, it means that the company is creating value and it is beneficial for the investors. WACC can be calculated as :
WACC = (E/V)Re + (D/V)Rd(1-Tc)
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V = % of financing that is equity = E+DE/V
D/V = % of financing that is debt
Tc = corporate tax rate
1-Tc means the cost of tax rate. The prevailing rate of tax is used to calculate the cost of debt. Cost of debt is calculated after considering the tax implications. Same is not the case for cost of equity. The cost of equity does not require 1-Tc because the cost does not include tax. In case of cost of debt, the debt is calculated by considering the rate of taxation to the company.
The cost of capital of a company is the rate at which long term debts as well as payments to creditors are made. It shows the minimum required rate of return for a project. Hence a positive npv of the project shows that the returns are positive and the project is desirable whereas a negative npv shows that the project should not be carried forward because its rate of return is lower than the desired rate of return of the company. Payback period is the amount of time within which the investment will earn a positive income. Npv shows a better valuation of a project because it helps decide the rate of return as well as the minimum required rate of return for the project to be viable. The payback period only shows the time period within which the investment will fetch returns, whereas npv reflects a positive or negative value of the investment. The cost of capital used as a discount rate shows that the investment is beneficial or not. A positive npv shows that the cost of capital exceeds the minimum discount value and the project is viable whereas a negative npv shows that it is not worthwhile to invest in the project.
Various factors are considered at the time of finalizing the capital base of a company. The CAPM model is used to decide the debt as well as equity of the company. While considering debt, the net debt is considered and not the gross debt. The minimum capital requirements should be considered by taking into account the risk free rate and the beta. The market rate of government bonds is also taken into consideration. An appropriate capital base consists of a good mix of debt as well as equity. Where there is a diversified portfolio, the company is free to invest as and when it wants so as to make sure the npv is positive. Adequate cash or liquidity should be maintained so as to stay safe in the industry in times of financial or economic crisis. Optimal capital base is challenging and difficult to determine but thorough research of the industry can help make the correct decision.
Bibliography
(n.d.). Retrieved from http://www.bis.org/publ/bcbs128b.pdf
