Weighted Average Cost of Capital (WACC) calculations have a number of inputs including the market value of equity. One reason that businesses calculate WACC is to determine the overall rate of return the company must earn to maintain its current stock value. Another reason is to determine whether the projected revenue of a new project or expansion will outweigh its costs, a measure referred to as "economic feasibility."
Market Value of Equity
The market value of equity is the dollar market value of a company's outstanding common stock. To calculate this amount, you multiply the current stock price by the number of shares outstanding. Since businesses use both debt and equity financing, using only the market value of equity is not an adequate measure in determining the cost of capital or evaluating the return rate the stock must average to maintain its current value.
When a business needs to finance a new project or acquisition, it must know the cost of financing -- in other words, how much interest will it have to pay for each dollar of financing used for the project. This can be determined by calculating WACC and using one of the following inputs: cost of equity(Re); cost of debt (Rd); market value of equity (E); market value of debt (D); total value of all equity and debt (V); equity financing percentage (E/V); debt financing percentage (D/V) and the businesses corporate tax rate (Tc).
The WACC calculation looks like in equation form: E/V x Re + D/V) x Rd x (1-Tc). When a business makes interest payments on debt, referred to as an interest expense, it decreases its net income. The (1-Tc) part of the WACC calculation is a reflection of the reduction on tax payments owed due to a decrease in net income for interest expenses paid.
In this example, assume that a company's financials are as follows: market value of debt (D)=$300; market value of equity (E)=$400; cost of debt (Rd)=10 percent; cost of equity (Re)=20 percent; and the corporate tax rate is (Tc)=30 percent. The total value of equity and debt is (V)=$700 ($300 debt + $400 equity=$700). To calculate WACC: E/V is 400/700=.57; D/V is 300/700=.43 and Tc is 1-.30=.70. Plug in the numbers: (.57 x .20) + .43 x .10) x .7. This equation now looks like: .114 + .043 x .7 = .1441. Convert to a percentage and you have 14.41 percent, which means the company's stock must return at least 14.41 percent to maintain its current stock price. For new project financing under these conditions, the company pays 14 cents on every dollar of financing.
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