Weighted average cost of capital (WACC) is a calculation used as a standard of comparison for a number of different business decisions. As it is based on rates of return that are determined by the market or observable from published data, it provides a useful measure of how well a company is creating shareholder value and its current value.
The weighted average cost of capital (WACC) is a method used to calculate the average cost of capital to a company, weighted according to the proportion of equity, debt and other types of capital. This cost of capital represents the discount rate that should be used for capital budgeting calculations to determine whether a given project or activity generates a sufficient expected return to compensate for its risks.
A company producing a return of 20% with a WACC of 11% is creating ₹0.09 of value for every Indian rupee of capital. On the other hand, a company returning less than its WACC is destroying value – even if it is profitable. WACC is also used as the discount rate applied to future cash flows for deriving a business’s net present value. All else being equal, the WACC of a firm increases as the beta and rate of return on equity increases, as an increase in WACC notes a decrease in valuation and a higher risk. The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing:
= cost of equity.
= cost of debt.
= market value of the firm’s equity.
= market value of the firm’s debt.
= percentage of financing that is equity.
= percentage of financing that is debt.
= corporate tax rate.
So, if a company has an enterprise value that was weighted 2:1 in favour of equity and cost of debt was 4%, then WACC would be 8%, the weighted average of 4% and 10% on a one-third: two-thirds basis. This means though that to calculate WACC, investors need to determine the company’s cost of equity and cost of debt. Calculating the latter is straightforward; calculating the former is not and this gives rise to significant variations in the WACC for companies when calculated by different analysts.
Cost of equity
The cost of equity is the equity holders’ required rate of return. This is not immediately observable and must be derived from those market variables that can be observed. The capital asset pricing model is the most commonly accepted method for calculating cost of equity. This expresses the cost of equity as the opportunity cost of investing in the equity, taking account of the risks involved. It adds the risk free rate of return that investors are giving up and which they could earn simply by buying medium-term government bonds, to the overall market equity risk premium plus an adjustment for the riskiness of this particular company’s shares.
Cost of debt
If a company raised all of its capital from debt then the cost of that capital would be relatively straightforward to calculate. It would essentially be the rate of interest paid by the company on bank loans, overdrafts and bonds. The rate applied to determine the cost of debt (Rd) should be the current market rate the company is paying on its debt. If the company is not paying market rates, an appropriate market rate payable by the company should be estimated. As companies benefit from the tax deductions available on interest paid, the net cost of the debt is actually the interest paid less the tax savings resulting from the tax-deductible interest payment. Therefore, the after-tax cost of debt is Rd (1 – corporate tax rate).