Weighted Average Cost of Capital

What is Weighted Average Cost of Capital (WACC)?

WACC, or Weighted Average Cost of Capital, is a financial metric that represents the average rate of return a company is expected to pay to its investors for using their capital. It takes into account the cost of various sources of capital, including equity and debt, and assigns weights to each based on their proportion in the company’s overall capital structure. In essence, WACC reflects the blended cost of financing for a company, considering both equity and debt components. By doing so, WACC provides a holistic view of the cost of capital, serving as a crucial benchmark for assessing the feasibility of investment opportunities.

How to Calculate WACC?

The formula for calculating WACC is:

WACC=(E/V×Re)+(D/V×Rd×(1−TaxRate))

Where:

• E is is market value of equity,
• D is the market value of debt,
• V is the Total Capital invested in the business (V = Total market value of the company’s equity + Debt),
• Re is the cost of equity
• Rd is the cost of debt, and
• The tax rate represents the corporate tax rate, accounting for the tax shield effect on debt.

The market value of equity is the total value of a company’s outstanding shares of stock (Market Capitalization). It is calculated by multiplying the current market price per share by the total number of outstanding shares.

Market value of Debt is value of Company’s debt listed in the market. In case the debt is unlisted then book value of debt should be considered for calculating the Value of debt.

The cost of equity is determined using the Capital Asset Pricing Model (CAPM), factoring in the risk-free rate, market risk premium, and beta. This represents the return required by equity investors.

The cost of debt considers the interest rates paid on borrowed capital. It reflects the cost of servicing debt and is often adjusted for tax benefits due to interest expense (which is tax deductible).

By considering the weights of each component based on their proportion in the capital structure, WACC provides a comprehensive measure of the average cost of capital for a company. This metric is widely used in financial decision-making, including project valuation, investment analysis, and determining the feasibility of various financing options.

Example – Let’s walk through a simplified example to illustrate how to calculate WACC. Suppose we have a fictional company, XYZ Inc., with the following details:

1. Current Share Price: $2
2. No. of shares outstanding: 10 Million
3. Market value of Debt: $10 Million
4. Cost of Equity 10%
5. Cost of Debt 5%
6. Tax rate: 20%

WACC=(E/V×Re)+(D/V×Rd×(1−TaxRate))

Calculation –

1. E = Market Capitalization or Value of equity = Current share price x Total Outstanding shares

Market Capitalization or Value of equity = $2 x 10 million = $20 million

2. D = Market value of debt = $10 million

3. V = Total Capital Invested in the business = Value of Equity + Value of Debt = $20 million + $10 million = $30 million

4. Weight of Equity = E/V = $20 million/$30 million = 0.67

5. Weight of Debt = D/V =$10 million/$30 million = 0.33

6. Re = Cost of Equity = 10%

7. Rd = Cost of debt = 5%

8. WACC = =(0.67×10%)+(0.33×5%×(1−20%)) = 0.067 + 0.013 = 0.08

    WACC for XYZ Inc. = 8%

This means that, on average, XYZ Inc. needs to generate a return of 8% on its investments to satisfy both equity and debt investors and maintain its current capital structure. This WACC figure can be used as a discount rate for evaluating investment opportunities or assessing the overall financial health of the company.

Cost of Equity and Capital for US companies

Why is WACC Important?

Weighted Average Cost of Capital (WACC) is a critical financial metric used in various aspects of corporate finance and investment analysis. Here are some key areas where WACC is commonly applied:

1. Capital Budgeting and Investment Analysis: WACC is used to discount future cash flows in capital budgeting decisions/ project evaluation. If the expected return on a project exceeds the WACC, the project is considered financially viable.
2. Valuation of Companies: Enterprise value or Intrinsic value of a business is equal to the sum of future value of all cash flows from the business. WACC is employed to estimate the enterprise value of a company. By discounting the projected future cash flows at the WACC, analysts can determine the present value of a company.
3. Mergers and Acquisitions (M&A): WACC is crucial in determining the cost of acquiring another company. Acquirers use WACC to evaluate whether the potential returns from the acquisition exceed the cost of capital.
4. Setting Financial Goals: WACC assists companies in setting financial goals. It serves as a benchmark for internal rate of return (IRR) expectations and helps in aligning financial strategies with shareholder expectations.
5. Risk Assessment: WACC reflects the risk-return profile of a company. A higher WACC may indicate a riskier investment, influencing strategic decisions and risk management strategies.
6. Credit Rating Assessment: Credit rating agencies may use WACC as a factor in assessing a company’s creditworthiness. A higher WACC may impact a company’s credit rating and borrowing costs.

Limitations of WACC

While the Weighted Average Cost of Capital (WACC) is a widely used financial metric, it has certain limitations that should be acknowledged when making financial decisions. Here are the key limitations of using WACC:

1. Assumes Constant Capital Structure: WACC assumes a constant capital structure over time. In reality, companies may alter their capital structure, especially when raising funds or undergoing significant financial changes. The assumption of a fixed capital structure can lead to inaccuracies in long-term analyses.
2. Ignores Project-Specific Risks: WACC treats all projects within a company equally, assuming that they have the same level of risk. However, different projects may have distinct risk profiles. Ignoring project-specific risks can result in suboptimal investment decisions, especially in industries with diverse project risk characteristics.
3. Subject to Assumptions and Estimates: Calculating WACC involves making assumptions and estimates, especially when determining the cost of equity. Small changes in these inputs can significantly impact WACC calculations, leading to potential inaccuracies.

Understanding these limitations allows financial professionals to use WACC judiciously and consider alternative approaches when necessary. While WACC is a valuable tool, it should be part of a broader financial analysis that considers the specific context and characteristics of the company and its projects.