Over the last two issues, we have explored the concept of the weighted average cost of capital (WACC). Last month, we explained how the after-tax WACC can be calculated using the following formula:
\(WACC\: = \: 1 – T \times \frac{D}{V} \times r_d + \frac{p}{V} \times r_p + \frac{E}{V} \times r_e\)
Where D is the company’s outstanding debt, rd is the expected return on debt, P is the value of the company’s preferred stock, rp is the expected return on preferred stock, E is the market value of the company’s issued shares, re is the expected return on equity,V is the total value of the company (defined as V = D + P + E) and T is the company’s marginal tax rate, or the rate at which any rebate on interest payments are received.
Difficulties with WACC
Although the after-tax WACC formula outlined above is the most commonly used by companies seeking to evaluate their investment activities, it is important to remember its limitations.
- WACC is, as its name implies, an average measure. This is an average across different operating units within the company as a whole. It is also an average of different forms of financing over time. Any new financing will affect the overall cost of capital.
- The formula assumes the correct calculation of both the expected return on debt and the expected return on equity. Both of these are almost impossible to calculate accurately. The expected return on debt is not the same as the current bond rate or the bank loan rate, as neither includes an assessment of the credit risk, which is the risk of potential default. The expected return on equity is even more difficult to evaluate as every shareholder’s expected returns are different.
- The formula implies that the cost of capital is determined by the expected returns on debt, equity and any other sources of financing. In practice, the expected returns are themselves determined by the risk appetite of the company as a whole – investors will want a higher return when investing in a riskier business. In other words, the inherent risk of the company’s activities determines both the expected returns and the WACC.
Because the WACC formula is based on a series of assumptions, it will never be completely accurate. Nonetheless, it is a very useful measure. Users simply need to be aware of its limitations.
