Weighted Average Cost of Capital (WACC)
The weighted average cost of capital (WACC) is a financial ratio that calculates a company’s cost of financing and acquiring assets by comparing the debt and equity structure of the business. In other words, it measures the weight of debt and the true cost of borrowing money or raising funds through equity to finance new capital purchases and expansions based on the company’s current level of debt and equity structure.
Management typically uses this ratio to decide whether the company should use debt or equity to finance new purchases.
What is WACC?
This ratio is very comprehensive because it averages all sources of capital; including long-term debt, common stock, preferred stock, and bonds; to measure an average cost of borrowing funds. It is also extremely complex. Figuring out the cost of debt is pretty simple. Bonds and long-term debt are issued with stated interest rates that can be used to compute their overall cost. Equity, like common and preferred shares, on the other hand, does not have a readily available stated price on it. Instead, we must compute an equity price before we apply it to the equation.
That’s why many investors and creditors tend not to focus on this measurement as the only capital price indicator. Estimating the cost of equity is based on several different assumptions that can vary between investors. Let’s take a look at how to calculate WACC.
The WACC formula is calculated by dividing the market value of the firm’s equity by the total market value of the company’s equity and debt multiplied by the cost of equity multiplied by the market value of the company’s debt by the total market value of the company’s equity and debt multiplied by the cost of debt times 1 minus the corporate income tax rate. Wow, that was a mouthful. Here’s what the equation looks like.
- Re = the cost of equity
- Rd = the cost of debt
- E = the market value of the company’s equity
- D = the market value of the company’s debt
- V = the total market value of the company’s combined debt and equity or E + D
- E/V = percentage of total financing consisting of equity
- D/V = percentage of total financing consisting of debt
- Tc = the corporate income tax rate
Now let’s break the WACC equation down into its elements and explain it in simpler terms. Here’s a list of the elements in the weighted average formula and what each mean.
The WACC calculation is pretty complex because there are so many different pieces involved, but there are really only two elements that are confusing: establishing the cost of equity and the cost of debt. After you have these two numbers figured out calculating wacc is a breeze.
The cost of equity, represented by Re in the equation, is hard to measure precisely because issuing stock is free to company. A company doesn’t pay interest on outstanding shares. In addition, each share of stock doesn’t have a specified value or price. It simply issues them to investors for whatever investors are willing to pay for them at any given time. When the market it high, stock prices are high. When the market is low, stock prices are low. There’s no real stable number to use. So how to measure the cost of equity?
We need to look at how investors buy stocks. They purchase stocks with the expectation of a return on their investment based on the level of risk. This expectation establishes the required rate of return that the company must pay its investors or the investors will most likely sell their shares and invest in another company. If too many investors sell their shares, the stock price could fall and decrease the value of the company. I told you this was somewhat confusing. Think of it this way. The cost of equity is the amount of money a company must spend to meet investors’ required rate of return and keep the stock price steady.
Compared with the cost of equity, the cost of debt, represented by Rd in the equation, is fairly simple to calculate. We simply use the market interest rate or the actual interest rate that the company is currently paying on its obligations. Keep in mind, that interest expenses have additional tax implications. Interest is typically deductible, so we also take into account the amount of tax savings the company will be able to take advantage of by making its interest payments, represented in our equation Rd(1 – Tc).
So what does all this mean?
To put it simply, the weighted average cost of capital formula helps management evaluate whether the company should finance the purchase of new assets with debt or equity by comparing the cost of both options. Financing new purchases with debt or equity can make a big impact on the profitability of a company and the overall stock price. Management must use the equation to balance the stock price, investors’ return expectations, and the total cost of purchasing the assets. Executives and the board of directors use weighted average to judge whether a merger is appropriate or not.
Investors and creditors, on the other hand, use WACC to evaluate whether the company is worth investing in or loaning money to. Since the WACC represents the average cost of borrowing money across all financing structures, higher weighted average percentages mean the company’s overall cost of financing is greater and the company will have less free cash to distribute to its shareholders or pay off additional debt. As the weighted average cost of capital increases, the company is less likely to create value and investors and creditors tend to look for other opportunities.
You can think of this as a risk measurement. As the average cost increases, the company must equally increase its earnings and ability to pay the higher costs or investors won’t see a return and creditors won’t be repaid. Investors use a WACC calculator to compute the minimum acceptable rate of return. If their return falls below the average cost, they are either losing money or incurring opportunity costs.
Let’s take a look at an example. Assume the company yields an average return of 15% and has an average cost of 5% each year. The company essentially makes a 10% return on every dollar it invests in itself. An investor would view this as the company generating 10 cents of value for every dollar invested. This 10-cent value can be distributed to shareholders or used to pay off debt.
Now let’s look at an opposite example. Assume that the company only makes a 10% return at the end of the year and has an average cost of capital of 15 percent. This means the company is losing 5 cents on every dollar it invests because its costs are higher than its returns. No investor would be attracted to a company like this. Its management should work to restructure the financing and decrease the company’s overall costs.
As you can see, using a weighted average cost of capital calculator is not easy or precise. There are many different assumptions that need to take place in order to establish the cost of equity. That’s why many investors and market analysts tend to come up with different WACC numbers for the same company. It all depends on what their estimations and assumptions were. This is why many investors use this ratio for speculation purposes and tend to value more concrete calculations for serious investing decisions.
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