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Understanding Weighted Average Cost of Capital (WACC)

Continuing Learning Series


Thursday, November 7, 2019


This article is a part of ACS Continuing Learning Series, which is a series of short articles, published by ACS Consulting at short regular intervals on a variety of subjects related to strategy, corporate finance, financial planning & analysis, business planning and performance management.

Subject: Corporate Finance


Relevance:


  • All accountants and accounting students.

  • Anyone who aspires to pursue a career as an investment analyst.

  • Anyone who aspires to pursue a career within corporate finance.

  • Anyone who is generally interested in capital markets and investment appraisals.


Introduction


The Cost of Capital & Weighted Average Cost of Capital is an integral part of a Discounted Cash Flow business valuation model and hence it is an important concept to understand for finance professionals, especially for investment banking and corporate development roles. This article attempts to explain the WACC concept by going through each component of the WACC calculation.


What Is Cost of Capital?


The easiest way to understand cost of capital is to think of it as the return which the providers of finance want for their funds. When analysts and investors discuss the cost of capital, they typically mean the weighted average of a firm's cost of debt and cost of equity blended together.


The cost of capital metric is used by companies internally to judge whether a capital project is worth the expenditure of resources, and by investors who use it to determine whether an investment is worth the risk compared to the return. The cost of capital depends on the mode of financing used. It refers to the cost of equity if the business is financed solely through equity, or to the cost of debt if it is financed solely through debt.

Most businesses (especially the larger ones) use a combination of debt and equity to finance their businesses and, for such companies, the overall cost of capital is derived from the weighted average cost of all capital sources, widely known as the Weighted Average Cost of Capital (WACC).


Weighted Average Cost of Capital (WACC)


The weighted average cost of capital is an integral part of a Discounted Cash Flow business valuation model and hence it is an important concept to understand for finance professionals, especially for investment banking and corporate development roles. This article attempts to go through each component of the WACC calculation.

Cost of capital represents a minimum target that a company must meet before it can generate value, and it is used extensively in the capital budgeting process to determine whether a company should proceed with a project.


The cost of capital concept is also widely used in economics and accounting. Another way to describe the cost of capital is the opportunity cost of making an investment in a business. Wise company management will only invest in initiatives and projects that will provide returns that exceed the cost of their capital.


Cost of capital, from the perspective on an investor, is the return expected by whoever is providing the capital for a business. In other words, it is an assessment of the risk of a company's equity. In doing this an investor may look at the volatility (beta) of a company's financial results to determine whether a certain stock is too risky or would make a good investment.


A firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of capital across all sources, including common shares, preferred shares, and debt. The cost of each type of capital is weighted by its percentage of total capital and they are added together. This article will provide a detailed breakdown of what WACC is, why it is used and how to calculate it.


WACC Formula & its Components


A firm's cost of capital is typically calculated using the weighted average cost of capital formula that considers the cost of both debt and equity capital. Each category of the firm's capital is weighted proportionately to arrive at a blended rate, and the formula considers every type of debt and equity on the company's balance sheet, including common and preferred stock, bonds and other forms of debt.


The WACC formula is given below:


WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))


Where:


E = market value of the firm’s equity (market cap)

D = market value of the firm’s debt

V = total value of capital (equity plus debt)

E/V = percentage of capital that is equity

D/V = percentage of capital that is debt

Re = cost of equity (required rate of return)

Rd = cost of debt (yield to maturity on existing debt)

T = tax rate


The purpose of WACC is to determine the cost of each part of the company’s capital structure based on the proportion of equity, debt, and preferred stock it has. Each component has a cost to the company. The company pays a fixed rate of interest on its debt and a fixed yield on its preferred stock. Even though a firm does not pay a fixed rate of return on common equity, it does often pay dividends in the form of cash to equity holders.


Understanding First Part of The Formula


To fully understand the WACC concept and the makeup of its formula, let us break it down into parts easy to understand.


Cost of Equity


The cost of equity is calculated using the Capital Asset Pricing Model (CAPM) which equates rates of return to volatility (risk vs reward).


Below is the formula for the cost of equity:


Re = Rf + β × (Rm − Rf)


Where:


Rf = the risk-free rate (typically the 10-years Govt. treasury bond yield)

β = equity beta (levered)

Rm = annual return of the market


The cost of equity is an implied cost or an opportunity cost of capital. It is the rate of return shareholders require, in theory, in order to compensate them for the risk of investing in the stock. The Beta is a measure of a stock’s volatility of returns relative to the overall market.


Risk-free Rate


The risk-free rate is the return that can be earned by investing in a riskless security, e.g., Govt. treasury bonds. Typically, the yield of the 10-year Govt. Treasury bonds/bills is used for the risk-free rate.


Equity Risk Premium (ERP)


Equity Risk Premium (ERP) is defined as the extra yield that can be earned over the risk-free rate by investing in the stock market. One simple way to estimate ERP is to subtract the risk-free return from the market return. This information will normally be enough for most basic financial analysis. However, in reality, estimating ERP can be a much more detailed task.


Levered Beta


Beta refers to the volatility or riskiness of a stock relative to all other stocks in the market. There are a couple of ways to estimate the beta of a stock. The first and simplest way is to calculate the company’s historical beta using regression analysis. The second and more thorough approach is to make a new estimate for beta using public company comparables. To use this approach, the beta of comparable companies is taken from and the unlevered beta for each company is calculated.


Unlevered Beta = Levered Beta / ((1 + (1 – Tax Rate) * (Debt / Equity))

Levered beta includes both business risk and the risk that comes from taking on debt. However, since different firms have different capital structures, unlevered beta (asset beta) is calculated to remove additional risk from debt in order to view pure business risk. The average of the unlevered betas is then calculated and re-levered based on the capital structure of the company that is being valued.


Levered Beta = Unlevered Beta * ((1 + (1 – Tax Rate) * (Debt / Equity))

In most cases, the firm’s current capital structure is used when beta is re-levered. However, if there is information that the firm’s capital structure might change in the future, then beta would be re-levered using the firm’s target capital structure.

After calculating the risk-free rate, equity risk premium, and levered beta, the cost of equity = risk-free rate + equity risk premium * levered beta.


Understanding 2nd Part of The Formula


Determining the cost of debt and preferred stock is probably the easiest part of the WACC calculation.


Cost of Debt & Preferred Stock


Every company has to chart out its financing strategy at an early stage. The cost of capital becomes a critical factor in deciding which financing track to follow i.e. debt, equity, or a combination of the two.


Early-stage companies seldom have sizable assets to pledge as collateral for debt financing, so equity financing becomes the default mode of funding for most of them. Less-established companies with limited operating histories will pay a higher cost for capital than older companies with solid track records since lenders and investors will demand a higher risk premium for the former.


The cost of debt is merely the interest rate paid by the company on its debt. However, since interest expense is tax-deductible, the debt is calculated on an after-tax basis as follows:


In more precise words, the cost of debt is the yield to maturity on the firm’s debt and similarly, the cost of preferred stock is the yield on the company’s preferred stock. Simply multiply the cost of debt and yield on preferred stock with the proportion of debt and preferred stock in a company’s capital structure, respectively.


Since interest payments are tax-deductible, the cost of debt needs to be multiplied by (1 – tax rate), which is referred to as the value of the tax shield. This is not done for preferred stock because preferred dividends are paid with after-tax profits.

Take the weighted average current yield to maturity of all outstanding debt then multiply it one minus the tax rate and you have the after-tax cost of debt to be used in the WACC formula.


The cost of debt can also be estimated by adding a credit spread to the risk-free rate and multiplying the result by (1 - T).


Simple Example


Now let us look at a very simple example to put the things together. Consider an enterprise with a capital structure consisting of 60% equity and 40% debt; its cost of equity is 12% and after-tax cost of debt is 8%.


Therefore, plugging these values into the formula, its WACC would be:


(0.6 x 12%) + (0.4 x 8%) = 10.4%


This is the cost of capital that would be used to discount future cash flows from potential projects and other opportunities to estimate their net present value (NPV) and the ability to generate value.


Companies strive to attain the optimal financing mix based on the cost of capital for various funding sources. Debt financing has the advantage of being more tax efficient than equity financing since interest expenses are tax deductible and dividends on common shares are paid with after-tax dollars. However, too much debt can result in dangerously high leverage, resulting in higher interest rates sought by lenders to offset the higher default risk.


The Cost of Capital and Tax Considerations


One element to consider in deciding to finance capital projects via equity or debt is the possibility of any tax savings from taking on debt since the interest expense can lower a firm's taxable income, and thus, its income tax liability.


However, the Modigliani-Miller Theorem (M&M) states that the market value of a company is independent of the way it finances itself and shows that under certain assumptions, the value of leveraged versus non-leveraged firms are equal, in part because other costs offset any tax savings that come from increased debt financing.


What is WACC used for?


Every industry has its own prevailing cost of capital. For some companies, the cost of capital is lower than their discount rate. Some finance departments may lower their discount rate to attract capital or raise it incrementally to build in a cushion depending on how much risk they are comfortable with.


The Weighted Average Cost of Capital serves as the discount rate for calculating the Net Present Value (NPV) of a business. It is also used to evaluate investment opportunities, as it is considered to represent the firm’s opportunity cost. Thus, it is used as a hurdle rate by companies.


A company will commonly use its WACC as a hurdle rate for evaluating mergers and acquisitions (M&A), as well as financial modeling of internal investments. If an investment opportunity has a lower Internal Rate of Return (IRR) than its WACC, it should buy back its own shares or pay out a dividend instead of investing in the project.


The Difference Between Cost of Capital and Discount Rate


The cost of capital and discount rate are somewhat similar and are often used interchangeably. Cost of capital is often calculated by a company's finance department and used by management to set a discount rate (or hurdle rate) that must be beaten to justify an investment.


That said, a company's management should challenge its internally-generated cost of capital number, as it may be so conservative as to deter investment. Cost of capital may also differ based on the type of project or initiative; a highly innovative but risky initiative should carry a higher cost of capital than a project to update essential equipment or software with proven performance.


Nominal vs Real Weighted Average Cost of Capital


Nominal free cash flows (which include inflation) should be discounted by a nominal WACC and real free cash flows (excluding inflation) should be discounted by a real weighted average cost of capital. Nominal is most common in practice, but it’s important to be aware of the difference.



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