Finance involves two key areas for decision making: procurement of funds and application of funds. In effect both the decision are critical from a company’s standpoint. A company is willing to invest in a new project as long as it increases the shareholder’s wealth and generates a reasonable return over the cost of procuring the capital.

Lets suppose a company decides to invest in a project which involves application of funds decision as per above. Although its impossible to predict the future cash flow to be generated if the project is undertaken, however some sort of analysis and prediction is involved to enable managers to take decision. Based on certain assumptions and probabilities future cash flows are calculated for the tenure of the project involved. Initial investment is known with certainty as its required in year zero.

Looking at the above situation one thing is clear that you cannot simply add up all the predicted future cash inflows and subtract the sum from the initial investment to come to a decision as to the project’s viability. The simple reason behind this is that as time passes by the real value of money deteriorates. So its safe to conclude that money has got time value and an individual would prefer a dollar today as compared to a dollar a year later because of two strong reason: Inflation drops the purchasing power of a dollar a year down the line and interest can be earned if the dollar is invested today to generate interest + principal a year hence.

So all the future cash flows occurring at different point in times need to be discounted back to year zero and aggregated in order to evaluate the viability of the proposed project. This throws an obvious question as to what discounting rate to be used? Answer to that is Weighted Average Cost of Capital or popularly known as WACC.

Broadly speaking a company has two major ways in which it can finance the capital requirement of its new project: debt and equity. Since the company needs to pay back interest to the debtholders (cost of debt) and dividends to the equityholders (cost of equity), together they form the total cost of capital procurement from the companies standpoint. Usually companies uses a mix of both debt and equity to fund its new project and hence we need to find the weights of individual source of funds (debt or equity) in order to calculate the WACC. Now how do we measure weights, its simply the market value of a source divided by the total market value of the firm. Its important to note that market value weights are considered here rather than book value since we are calculating the expected cost of the capital to be invested in the new project.

WACC is then calculated by simply multiplying the cost of respective source with its respective market based weights in the total capital structure of the company. WACC takes into consideration the overall cost of capital of the company while evaluating the project’s viability.

WACC is calculated as follows:

WACC = [{cost of debt * (1-t) * D/V} + {cost of equity * E/V}]
Where D = Value of Debt
E = Value of Equity
V = Total Value of Firm
Cost of debt = Interest rate required by debtholders.
Cost of Equity = Expected rate of return calculated using the CAPM model.

A closer look at the above formula shows that a company can lower its overall cost of capital or the WACC if it increases the debt component in its capital structure vis-a-vis equity. This is because interest is a tax deductible expenditure while dividend is not. In other words increase in debt will involve more interest expenses which is an allowable expense while calculating corporate tax and hence saves tax to a certain extent.

If that is to be true why do company don’t heavily rely on debt financing. Well, simply because the more debt in the capital structure exposes the company to higher risk of financial distress. So the challenge often faced by firms is to have appropriate level of debt and equity to reduce the overall cost of capital without jeopardizing the overall financial health of the firm.

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