Lesson 1, Topic 1
In Progress

Weighted Average Cost of Capital (WACC)

Warning: Attempt to read property "post_author" on null in /home/palanfou/evarsity.my/wp-content/themes/buddyboss-theme/learndash/ld30/topic.php on line 196

The weighted average cost of capital (WACC) is a calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation.

A firm’s WACC increases as the beta and rate of return on equity increase because an increase in WACC denotes a decrease in valuation and an increase in risk.

WACC can be calculated using formula;

WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight, and then adding the products together to determine the value. In the above formula, E÷(D+E) represents the proportion of equity-based financing, while D÷(D+E) represents the proportion of debt- based financing. The WACC formula thus involves the summation of two terms. The former represents the weighted value of equity-linked capital, while the latter represents the weighted value of debt- linked capital.

Explaining the Formula Elements

Cost of equity (re) can be a bit tricky to calculate since share capital does not technically have an explicit value. When companies pay a debt, the amount they pay has a predetermined associated interest rate that debt depends on the size and duration of the debt, though the value is relatively fixed. On the other hand, unlike debt, equity has no concrete price that the company must pay. Yet that does not mean there is no cost of equity.

Since shareholders will expect to receive a certain return on their investments in a company, the equity holders’ required rate of return is a cost from the company’s perspective, because if the company fails to deliver this expected return, shareholders will simply sell off their shares, which leads to a decrease in share price and in the company’s value. The cost of equity, then, is essentially the amount that a company must spend in order to maintain a share price that will satisfy its investors.

Calculating the cost of debt (rd), on the other hand, is a relatively straightforward process. To determine the cost of debt, you use the market rate that a company is currently paying on its debt. If the company is paying a rate other than the market rate, you can estimate an appropriate market rate and substitute it in your calculations instead.

There are tax deductions available on interest paid, which are often to companies’ benefit. Because of this, the net cost of a company’s debt is the amount of interest it is paying, minus the amount it has saved in taxes as a result of its tax-deductible interest payments. This is why the after-tax cost of debt is rd (1 – t) where t represents the corporate tax rate.

Learning From WACC

WACC is the average of the costs of these types of financing, each of which is weighted by its proportionate use in a given situation. By taking a weighted average in this way, we can determine how much interest a company owes for each dollar it finances.

Debt and equity are the two components that constitute a company’s capital funding. Lenders and equity holders will expect to receive certain returns on the funds or capital they have provided. Since the cost of capital is the return that equity owners (or shareholders) and debt holders will expect, WACC indicates the return that both kinds of stakeholders (equity owners and lenders) can expect to receive. Put another way, WACC is an investor’s opportunity cost of taking on the risk of investing money in a company.

A firm’s WACC is the overall required return for a firm. Because of this, company directors will often use WACC internally in order to make decisions, like determining the economic feasibility of mergers and other expansionary opportunities. WACC is the discount rate that should be used for cash flows with a risk that is similar to that of the overall firm.

To help understand WACC, try to think of a company as a pool of money. Money enters the pool from two separate sources: debt and equity. Proceeds earned through business operations are not considered a third source because, after a company pays off debt, the company retains any leftover money that is not returned to shareholders (in the form of dividends) on behalf of those shareholders.

Who Uses WACC?

Securities analysts frequently use WACC when assessing the value of investments and when determining which ones to pursue. For example, in discounted cash flow analysis, one may apply WACC as the discount rate for future cash flows in order to derive a business’s net present value. WACC may also be used as a hurdle rate against which companies and investors can gauge return on invested capital (ROIC) performance. WACC is also essential in order to perform economic value- added (EVA) calculations.

Investors may often use WACC as an indicator of whether or not an investment is worth pursuing. Put simply, WACC is the minimum acceptable rate of return at which a company yields returns for its investors. To determine an investor’s personal returns on an investment in a company, simply subtract the WACC from the company’s returns percentage.

WACC vs. Required Rate of Return (RRR)

The required rate of return (RRR) is from the investor’s perspective, being the minimum rate an investor will accept for a project or investment. Meanwhile, the cost of capital is what the company expects to return on its securities. Learn more about WACC versus the required rate of return.

Limitations of WACC

The WACC formula seems easier to calculate than it really is. Because certain elements of the formula, like the cost of equity, are not consistent values, various parties may report them differently for different reasons. As such, while WACC can often help lend valuable insight into a company, one should always use it along with other metrics when determining whether or not to invest in a company.

Example of How to Use WACC

Suppose that a company yields returns of 20% and has a WACC of 11%. This means the company is yielding 9% returns on every dollar the company invests. In other words, for each dollar spent, the company is creating nine cents of value.

On the other hand, if the company’s return is less than WACC, the company is losing value. If a company has returns of 11% and a WACC of 17%, the company is losing six cents for every dollar spent, indicating that potential investors would be best off putting their money elsewhere.

As a real-life example, consider Walmart (NYSE: WMT). The WACC of Walmart is 4.2%. That number is found by doing a number of calculations. First, we must find the financing structure of Walmart to calculate V which is (D+E), which is the total market value of the company’s financing. For Walmart, to find the market value of its debt we use the book value, which includes long-term debt and long- term lease and financial obligations.

As of the end of its most recent quarter (Oct. 31, 2018), its book value of debt was $50 billion. As of Feb. 5, 2019, its market cap (or equity value) is $276.7 billion. Thus, V is $326.7 billion, or $50 billion + $276.7 billion. Walmart finances operations with 85% equity (E ÷ V, or $276.7 billion / $326.7 billion) and 15% debt (D ÷ V, or $50 billion ÷ $326.7 billion)

To find the cost of equity (re) one can use the capital asset pricing model (CAPM). This model uses a company’s beta, the risk-free rate, and the expected return of the market to determine the cost of equity. The formula is risk-free rate + beta * (market return – risk-free rate). The 10-year Treasury rate can be used as the risk-free rate and the expected market return is generally estimated to be 7%. Thus, Walmart’s cost of equity is 2.7% + 0.37 * (7% – 2.7%), or 4.3%.

The cost of debt is calculated by dividing the company’s interest expense by its debt load. In Walmart’s case, its recent fiscal year interest expense is $2.33 billion. Thus, its cost of debt is 4.7%, or $2.33 billion ÷ $50 billion. The tax rate can be calculated by dividing the income tax expense by income before taxes. In Walmart’s case, it lays out the company’s tax rate in the annual report, said to be 30% for the last fiscal year.

Finally, we’re ready to calculate Walmart’s weighted average cost of capital (WACC). The WACC is 4.2%, with the calculation being 85% * 4.3% + 15% * 4.7% * (1 – 30%).