What Is The Weighted Average Cost Of Capital?
Weighted average cost of capital (WACC) represents the combined cost of capital from all sources including debt & equity. A company’s WACC is its required rate of return that must be met in order to meet the obligations of it capital structure. WACC is perhaps the most commonly used discount rate in valuation models.
How To Calculate WACC
The WACC is not reported on financial statements and it can be difficult to find via third party organizations. However, WACC can be calculated using the formula below.
WACC = ( E/V x COE ) + ( D/V x COD x ( 1 – TR))
Where
E = Market Value Of Equity
D = Market Value Of Debt
V = Total Debt + Equity
COE = Cost Of Equity
COD = Cost Of Debt
TR = Tax Rate
This equation is shown in the following image via Boyko Wealth:
Understanding The WACC Formula
By multiplying the cost of debt & equity by the respected weighting in a firm’s capital structure, the WACC formula finds the average of the cost of these two capital sources. The cost of debt is then multiplied by the tax rate to account for the tax shield provided by interest payments.
Why Use WACC?
Once calculated, WACC can be utilized in many ways. One common use of WACC is as a discount rate. A discount rate is necessary to calculate net present value of prospective investments. Because WACC represents the average cost of raising capital, WACC is also compared to returns on investment metrics, like ROIC, to measure whether or not financing a project would create value. To an extent, WACC can also be analyzed as a stand-alone statistic. A low WACC indicates a company’s ability to easily attract investors and thus take on more capital whereas a high WACC is also associated with high risk companies.
WACC VS. ROIC
In order for an investment to create value, its return must be greater than its cost. This concept is demonstrated by subtracting the weighted average cost of capital (WACC) from return on invested capital (ROIC). The ability to out-earn the costs of capital is a highly desirable trait for a company as it demonstrates value. This is why companies with high ROIC, relative to their WACC, trade at premiums.
Limitations Of WACC
One limitation of WACC is the complexity of its calculation. An accurate WACC calculation requires all of the inputs to be correct. These inputs can be difficult to find especially for companies with various types of debt & equity, which also comes with several interest rates. These inputs are also subject to change day-to-day and are certain to change with the progression of time. This is why using a single discount rate in DCF or NPV analysis is ineffective. Another limitation to WACC is its implication of beta being a proper assessment of risk. Beta only measures risk from the prospective of market volatility. Beta does not account for fundamental and economic risks facing the company. As stated before, WACC can be somewhat useful as a stand-alone statistic. However, this form of WACC analysis should only be lightly preformed as WACC is most valuable when being compared to other metrics or being used in other calculations.
