lets try to understand whether this WACC is really a rocket science.....
What is cost of capital.... The cost of capital is simply the additional the things that you have to give to get money.... In simple terms to earn a salary to live, we have to spend sleepless nights spending times at the office....
In that simple scenario,
- Investment/funding requirement is to live
- cost of that capital is the hard work that we do(the portion that is actually beyond the preconditioned work), to get that money....
In a balance sheet language, to fund the fixed assets and the net working capital, what is the additional interest that we pay on Equity and Debt.
The share holders expected return on Equity is the cost of equity(Ke),
The interest rates that should be paid to gain a loan is the cost of debt(Kd), the other important thing when it comes to interest is, it is tax deductible(See the P &L of your company). Hence the original cost of debt should be, Kd(100%-t%)
When evaluating a project it is important that a company's WACC is used to reflect how much would be the cost of debt and cost of equity. Because those to are the only financing sources a company has mainly.
Hence to get an average figure = The Total cost of capital
The total capital
Capital generated from equity = Ve
Capital generated from debt = Vd
Total capital generated = Vd + Ve
Cost of equity = Ve*Ke
Cost of debt = kd*(100%-t%)*Vd
Total cost of capital = Ve*Ke + kd*(100%-t%)*Vd
WACC = Ke*Ve + Kd*(100%-t%)*Vd
Vd+Ve
So the next time your accountant tries to full you with greekish words like WACC, don't forget to ask him to deduct taxation when you take into account cost of debt..... :D
| EQUITY VE | FIXED ASSETS |
| DEBT VB | NET WORKING CAPITAL |
Sajja, good work mchn....
ReplyDeleteYou have explained it nicely...
Even I could understand it....
Problem...
What kind of taxes are applicable when you going to take a loan(t).....??? Then the loans are going to be use less ne machn...
To answer your question,
ReplyDeleteConsider the extract of a profit and loss account,
Net profit = 1000
Interest payable = (200)
Net profit before tax = 800
Tax( Percentage from net profit-30%)= (240)
Profit after tax = 560
Observe that the taxation is calculated after deducting tax, That means effectively you have paid 800 * (1-0.3),
Or in other words,
Actual Tax After tax
Net profit 1000 (300) 700
Interest cost (200) -(60) (140)
Profit 800 360 560
Thus observe the second line of the profit and loss statement extract, because of the tax implication the actual interest paid is 140.
But when it comes to return or the payment to the share holders, that is dividend, dividend is paid from the Profit after tax. Hence it is not tax deductible.
Hence when taking the cost of debt it is always important to keep in mind that there is the tax advantage, which would come that should be considered when calculating the WACC.