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A company’s weighted average cost of capital (WACC) is a financial metric that represents the average rate a company is expected to pay to finance its assets, whether through debt, equity, or a combination of both. WACC plays a crucial role in investment decisions, business valuations, and capital budgeting strategies.
A high WACC suggests that a company faces higher capital costs and may be perceived as a riskier investment. A low WACC, on the other hand, signals more favorable borrowing terms and lower equity demands, typically associated with stable, established businesses.
Key Takeaways
- WACC is the blended cost a company pays for its debt and equity.
- It helps determine if a company’s returns exceed its financing costs.
- A company’s WACC should be lower than its return on capital for a project to be profitable.
- WACC is industry-specific and is most useful when compared across similar companies.
- It is commonly used as a discount rate in valuation models like discounted cash flow (DCF) analysis.
What Is Weighted Average Cost of Capital (WACC) Used for?
A company’s WACC can be used to estimate the expected costs for all of its financing. This includes payments made on debt obligations (cost of debt) and the required rate of return demanded by ownership (cost of equity).
Most publicly listed companies have multiple funding sources. Therefore, WACC attempts to balance out the relative costs of different sources to produce a single cost of capital figure.
When calculating WACC, the cost that a company pays for capital can include the interest rate it pays on debt, which is the cost of debt, and the dividends it pays to shareholders, which is the cost of equity.
In theory, WACC represents the cost of raising one additional dollar of money. For example, a WACC of 5% means the company must pay an average of $0.05 to source an additional $1. This $0.05 may be the cost of interest on debt or the dividend/capital return required by private investors.
Example of a High WACC
Imagine a newly-formed widget company called XYZ Industries that must raise $10 million in capital so it can open a new factory. The company issues and sells 60,000 shares of stock at $100 each to raise the first $6,000,000. Because shareholders expect a return of 6% on their investment, the cost of equity is 6%. XYZ then sells 4,000 bonds for $1,000 each to raise the other $4,000,000 in capital. The people who bought those bonds expect a 5% return, so XYZ’s cost of debt is 5%.
The WACC combines the cost of both equity and debt funds. Assuming a 10% tax rate, the company’s WACC is:
WACC = (Cost of Debt * Weight of Debt * (1 – Tax Rate)) + (Cost of Equity * Weight of Equity)
WACC = (5% * 40% * (1 – 10%)) + (6% * 60%)
WACC = 5.4%
Let’s say the company evaluates that the projected annual return of the new factory will only be 3%. Because the WACC is higher than the expected return of the project, the project will not be undertaken as the amount earned from the factory does not exceed the cost of sourcing funds to build it.
Why Does WACC Matter?
WACC is an important consideration for corporate valuation in loan applications and operational assessment. Companies seek ways to decrease their WACC through cheaper sources of financing. Issuing bonds may be more attractive than issuing stock if interest rates are lower than the demanded rate of return on the stock.
Important
WACC is highly dependent on the company’s industry and nature of business. For example, real estate companies can often provide greater collateral for lower financing costs. Small technology firms often rely heavily on private investments at often higher upfront costs. Ensure you compare the WACC across similar companies to garner the best value from this calculation.
WACC and Diminishing Returns
There’s a law of diminishing returns in financing. If a company takes on too much debt initially, additional debt becomes more expensive due to the increased risk premium. This raises the company’s overall WACC and can limit growth.
Value investors might also be concerned if a company’s WACC is higher than its actual return. This is an indication that the company is losing value, and there are probably more efficient returns available elsewhere in the market.
Balance Sheet and Tax Implications
WACC inputs are derived from:
Equity financing offers no tax benefit, while debt financing may reduce taxable income, further lowering WACC.
What Is a Good Percentage for WACC?
WACC varies across industries. In addition, younger companies will often have higher WACC as they are riskier and must entice investments or incur debt at higher costs. In general, lower WACC calculations represent safer companies.
What Does WACC Indicate?
WACC indicates the blended cost a company is paying on its debt and equity. It is often used as the benchmark to gauge whether operations or projects are successful. If the WACC exceeds the company’s returns, the company is paying more to investors than it is earning.
How Do You Calculate WACC?
WACC is calculated by merging the weighted cost of equity with the weighted cost of debt (after factoring in tax benefits:
WACC = (Cost of Debt * Weight of Debt * (1 – Tax Rate)) + (Cost of Equity * Weight of Equity)
The Bottom Line
Weighted average cost of capital is an integral part of a discounted cash flow valuation and is a critically important metric to master for finance professionals. WACC is heavily used in corporate finance and investment banking roles, and it often sets the benchmark return a company must strive for.
