Understating the wide array of formulas, calculations and ratios used in the world of Forex (foreign exchange) trading can be a daunting task. One of the most important to understand is the Weighted Average Cost of Capital, or WACC, formula which is used to determine a company’s overall cost of capital. This article will provide an in-depth look into the WACC formula and how it is used in Forex trading.
What Is The Weighted Average Cost Of Capital (WACC)?
The weighted average cost of capital (WACC) is a measure of a company’s average cost of capital and also represents the minimum rate of return a company must earn on its investments to satisfy its investors. This cost is calculated from the rate of return required by each capital provider in proportion to its weight of the total capital structure. It is usually expressed as a percentage and represents the cost of the company’s available sources of financing and other available capital sources.
The WACC is the rate at which a company’s future cash flows need to be discounted to arrive at a present value for the business. It reflects the perceived risk of the company’s operations, and thus the riskiness of its capital structure. This rate of return is generally an average of the required returns of each capital provider.
Where Is WACC Applied?
WACC is used in financial projects or investments to measure the cost of capital. It is typically used to determine the company’s cost of capital, to assess the potential cost of a new project or investment, and to compare the cost of different sources of capital.
Additionally, the WACC allows companies to calculate the return on invested capital and the required return on new projects or investments. It is also used by investors in assessing future investments and in evaluating the company’s performance.
Determining The Weighted Average Cost Of Capital (WACC) Formula
The weighted average cost of capital can be calculated by using the following formula:
WACC = (E÷V x Re) + (D÷V x Rd x (1-Tc))
Where:
E = Total market value of equity held by investors
V = Total market value of company
Re = Cost of Equity
D = Total market value of debt held by investors
Rd = Cost of Debt
Tc = Effective tax rate
For example, if the company has $3,000,000 of equity and $2,000,000 of debt with a market value of $5,000,000, a cost of equity of 9%, a cost of debt of 6% and an effective tax rate of 21%. The WACC would be:
WACC = (E÷V x Re) + (D÷V x Rd x (1-Tc))
WACC = ($3,000,000/$5,000,000 x 0.09) + ($2,000,000/$5,000,000 x 0.06 x (1-0.21))
WACC = (0.054) + (0.041)
WACC = 0.095 or 9.5%.
With the WACC formula, companies are able to calculate the cost of capital and use this information to make decisions regarding investments, capital structure, and the future of the business. Understanding and calculating the WACC is essential to effective financial planning and decision making, as it provides investors and managers a clear view of the cost of the company’s capital.
