The weighted average cost of capital (WACC) is the minimum rate of return, on average, the company provides so that suppliers of funds are willing to lend money to the company. Capital consists of equity and debt, each of which has a cost. And, because companies do not use it in equal proportions (50:50), they must weigh it based on their importance (contribution) to the company’s capital structure.
For investors, WACC represents a return on investment. But, for companies, it is cost. It’s similar to when you borrow money at a bank. For banks, interest represents the return they receive. Meanwhile, for you, interest is the cost you have to pay.
WACC is vital for companies in making investment decisions in new projects or growing business. They must produce higher returns than WACC to satisfy their owners, creditors, and other capital providers.
What is capital structure
It represents the composition of debt and equity used by the company to finance its business. For book value, you can see the composition on the balance sheet in the financial statements.
The capital structure varies between companies and hence, implies different costs between them. Ideally, companies must achieve an optimal capital structure to minimize the weighted average capital cost. Low capital costs ultimately maximize the value of the company.
What are the components of capital structure
Broadly speaking, the company’s capital structure consists of two:
- Debt capital
- Equity capital
Debt capital arises because the company borrows money from another party on condition that it will be paid back with interest. Companies usually use it as expansion capital and will be repaid in the future. Examples are bank loans and bonds. Calculating the cost of debt capital is easier than equity.
For equity capital, suppliers contribute their money in exchange for the ownership of the company. So, we call the suppliers as shareholders. Equity consists of two, preferred shares and common shares.
The company has no obligation to pay shareholders as in debt capital. But, shareholders are very concerned about the company’s operations and growth. If debt capital suppliers get interest in return, shareholders potentially earn dividends and capital gains.
A company might have a simple capital structure or a complex capital structure. A simple capital structure consists of equity and debt instruments, without convertible items. Conversely, complex capital structures contain convertible instruments such as convertible preferred shares and convertible bonds.
Why use the weighted average cost of capital
As I mentioned, the composition of debt and equity is often unequal. Some companies may have more debt than equity. Conversely, other companies have more equity than debt.
As a result, the capital cost will vary depending on the part of each component. For this reason, we must weigh each component to get a more representative number of capital costs.
Usually, the capital structure will depend on the industry in which the company operates—different industries have different business environments. For example, when the industry enters a growth stage, the need for new investment and debt capital is higher than in a mature industry.
How to calculate the weighted average cost of capital
You need to add the cost of each component of capital, according to its portion to total capital. The weighted average cost of capital (WACC) formula is as follows.
WACC = (1- t) x rd x [D / (D + E)] + re [E / (D + E)]
- D = Market value of debt
- E = Market value of equity
- rd = Cost of debt
- re = Cost of equity
- t = Marginal tax rate
For example, a company has a capital structure of 60% debt and 40% equity. The pretax cost of debt is 8% and the cost of equity is 9%. The company’s marginal tax rate is 20%. So, we get WACC = (60%) (8%) (1 – 20%) + (40%) (9%) = 7.4%.
As a note, the weights you use in calculating WACC are based on the target capital structure. It is the capital structure the company wants to maintain over time.
But, if information about the target capital structure is not readily available, you can use weights in the company’s current capital structure. Weights of various components must be based on market value.
You can estimate the target capital structure from guidelines or management statements regarding the company’s capital structure policy. The final alternatives, you can also determine it from the average weighting of the comparable peers’ capital structure.
How to calculate the cost of debt
Debt often benefits companies because its cost is tax deducted. As in the WACC equation, the cost of debt is the after-tax interest rate [(1- t) x rd].
Calculating debt costs is relatively easy. Some companies usually have debts and report their details (lenders, principal amount, and interest rates) in the notes section of the financial statements. You could use the average interest rate of debt outstanding in representing the cost of debt.
But, if unavailable in the financial statement, you need to estimate it based on the debt’s interest rate with a similar principal and maturity.
Alternatively, if market interest rates are unavailable, you can also use two other approaches:
- Yield-to-maturity (YTM) approach
- Debt-rating approach
Under the YTM approach, the pretax cost of debt equals yield to maturity, which is the annual return on bonds purchased at current market prices and held to maturity. For example, YTM for corporate bonds with a tenor of 10 years is 9.36%, and the corporate tax rate is 20%, then debt costs are equal to 5.89% [(1-20%) x 9.36%].
Under the debt-rating approach, you estimate the pretax cost of debt by using bond yields of company peers with the same rating and debt maturity.
For example, a company has an AA rating, and its average debt maturity is 5 years. On the market, the yield on AA-rated bonds with a 5-year tenor is 5.78%. Then you can use this percentage as a pretax cost of debt. Hence, in the WACC calculation, the company’s debt costs are 4.62% [(1-20%) x 5.78%].
How to calculate the cost of equity
The company must estimate the rate of return stock investors (shareholders) require. If the company fails to fulfill it, shareholders will sell their shares, leading to a fall in its share price and company value.
The calculation of equity costs is a bit complicated and pretty much contains subjectivity. That’s because stock capital technically doesn’t have an explicit value, as is the interest rate in debt capital.
For calculations, you can use one of the following three approaches:
- Capital Asset Pricing Model (CAPM)
- Dividend discount model approach
- Bond yield plus risk premium approach
Well, here, I’m only going to discuss CAPM, a method widely used to calculate the cost of equity. For others, you can follow it on the corporatefinanceinstitute.com page.
CAPM states that the cost of equity is equal to a risk-free rate plus a premium to bear the risk if investing in a stock. The CAPM formula is as follows.
re = RF + βi [(E(RM) – RF)]
- re = Expected return of company share (cost of equity)
- RF = Risk-free rate
- βi = Beta of company shares, which measures the sensitivity of the company’s share returns to changes in market returns.
- E (RM) = Expected market return
- (E(RM) – RF) = Equity risk premium
Let’s take a simple example. For risk-free rates, you can use the 10-year government bond yield, for instance, at 5.06%. The company shares have a beta of around 0.37. Meanwhile, for market return expectations, you can use historical returns, for example, the average value is 10% in the last 30 years.
In this example, we can calculate the cost of equity as follows:
CAPM = 5.06% + [0.37 x (10% – 5.06%)] = 6.89%
What is the weighted average cost of capital used for
For companies, calculating the weighted average capital cost is one step to calculate the optimal capital structure. It is also useful for measuring the cost of funding future projects. Of course, companies should use the lowest capital costs to fund new projects.
The cost of capital tends to decrease when companies use higher debt as a source of funding. Companies can issue bonds rather than shares because they can get tax reduction benefits.
But, increasing debt results in an increase in interest expense. A higher degree of financial leverage increases the risk of bankruptcy, and capital suppliers don’t want it. Hence, companies need to calculate the right portion of the debt, so optimizes their capital structure.
There are many applications from WACC. Management uses it as a discount rate to make strategic decisions such as mergers or expansion projects.
Securities analysts use it to assess the current fair price of a company’s shares, whether overvalued or undervalued. They use WACC in valuations using the discounted cash flow model. WACC is the discount rate for future cash flows, which is useful for determining the company’s current value.
How to use the weighted average cost of capital (WACC) for a project
Internal rate of return (IRR) is one way to evaluate the attractiveness of a project or investment. And, in this case, you can use WACC together with IRR. WACC is acting as the required rate of return.
The project adds value to the company if the IRR value of the project exceeds WACC. For example, if the company’s WACC is 12%, the proposed project must have an IRR of 12% or higher. A higher value means that the project yields a higher return than the capital cost to fund it. Conversely, if the value is below WACC, the project must be rejected.
Likewise, if you use NPV to evaluate a project, WACC is a discount rate that reflects the company’s average risk.
But you need to remember. If you use WACC as the discount rate, you assume the project will have a constant capital structure and similar to the company’s target capital structure. You expect the project’s risk profile is relatively the same as the company. So, if the project has a higher risk than the company, then you need to add a risk premium to WACC to get a discount rate. Conversely, if the project has a lower risk, you need to adjust WACC to the bottom.
What are the advantages and disadvantages of WACC
Using WACC gives you insight into the more reasonable the cost of capital. You can use it together with other metrics when determining whether to invest in a company or not.
Although relatively easy to calculate, but results can vary. Some formulas, such as equity costs, give more flexibility in the calculation. The market value of the company’s equity is dynamic. It always changes, along with the movement of the company’s stock price. As a result, it results in an inaccurate estimation of the cost of equity capital.
Beta numbers depend on the data you use in the regression, weekly, monthly, and for how many years, whether two years, three years or five years. Each will produce a different number.
The expected market return often uses historical returns. The question is, does that make sense? Will future performance be the same as past performance?