Cost of Capital vs. WACC !
Weighted
average cost of capital and cost of capital are both concepts of finance that
represent the cost of money invested in a firm either as a form of debt or
equity or both. Cost of equity refers to the cost of selling shares to
shareholders to obtain equity capital and cost of debt refers to the cost or
the interest that must be paid to lenders for borrowing money. These two terms
cost of capital and WACC are easily confused as they are quite similar to each
other in concept. The following article will explain each providing formulas on
how they are calculated.
What is Cost of Capital?
Cost
of capital is the total cost in obtaining debt or equity capital. In order for
an investment to be worthwhile, the rate of return on the investment must be
higher than the cost of capital. Taking an example, the risk levels of two
investments, Investment A and Investment B, are the same. For investment A, the
cost of capital is 7%, and the rate of return is 10%. This provides an excess
return of 3%, which is why investment A should go through. Investment B, on the
other hand, has cost of capital of 8% and rate of return of 6%. Here, there is
no return for the cost incurred and investment B should not be taken into
consideration.
However,
assuming that the treasury bills have the lowest level of risk, and have a
return of 5%, this may be more attractive than both options since risk levels
are very low, and return on 5% is guaranteed since the T bills are government
issued.
What is WACC?
WACC
is a bit more complex than the cost of capital. WACC is calculated by giving
weights to the company’s debt and capital in proportion to the amount in which
each is held. WACC is usually calculated for various decision making purposes
and allows the business to determine their levels of debt in comparison to
levels of capital.
The
formula for calculation is; WACC = (E / V) x Re + (D / V) x Rd x (1 – Tc).
Here, E is the market value of equity and D is the market value of debt and V
is the total of E and D. Re is the total cost of equity and Rd is the cost of
debt. Tc is the tax rate applied to the company.
What is the difference between Cost
of Capital and WACC?
Cost
of capital is the total of cost of debt and cost of equity, whereas WACC is the
weighted average of these costs derived as a proportion of debt and equity held
in the firm.
Both,
Cost of capital and WACC, are made use in important financial decisions, which
include merger and acquisition decisions, investment decisions, capital
budgeting, and for evaluating a company’s financial performance and stability.
Summary:
Cost of Capital vs WACC
- Weighted
average cost of capital and cost of capital are both concepts of finance that
represent the cost of money invested in a firm either as a form of debt or
equity or both.
- In
order for an investment to be worthwhile, the rate of return on the investment
must be higher than the cost of capital.
- WACC
is calculated by giving weights to the company’s debt and capital in proportion
to the amount in which each is held.
