The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both.
Why would you be interested in knowing the cost of debt, equity and eventually the cost of capital?
Money has a time value, and if we want to know if it is convenient for us to undertake an investment, we must discount the invested capital for the proper discount rate.
For instance, imagine for a second you want to invest in a new venture, but you also want to make 25% annually on that venture. Thus you invest $100K, and you want to make $25K by the end of the year.
The 25% is your hurdle rate. Consequently, if your expected return on this investment isn’t at least 25%, you won’t go for it. To compute the expected return on an equity investment, we will have to determine the cost of equity.
Imagine that you assessed the cost of equity on the new venture and it turns out to be 15%. This return is not satisfactory enough for you to invest. Therefore you will not commit your money.
On the other hand, if you want to know the proper discount rate for the overall asset of the organization we will have to resort to the WACC formula:
In short, to compute the cost of capital, we will have to adjust the cost of equity and the cost of debt according to the weight of each component of the capital structure of the firm.
For instance, the same company will have a lower or higher cost of capital according to the financing mix it chose to finance its operations.
Component
Description
Definition
The Weighted Average Cost of Capital (WACC) is a financial metric that represents the average cost a company incurs to finance its operations and investments. It takes into account the cost of debt, cost of equity, and cost of preferred stock, each weighted by its respective proportion in the company’s capital structure. WACC is used to evaluate the attractiveness of potential investments or projects and is a crucial factor in determining a company’s discount rate for financial valuation. It reflects the minimum return required by investors to provide funding.
Components of WACC
– Cost of Debt (Rd): This represents the interest rate a company pays on its outstanding debt, including loans and bonds. It is a pre-tax cost and is typically based on the interest expense. – Cost of Equity (Re): This reflects the return expected by shareholders or investors who provide equity financing. It is often estimated using models such as the Capital Asset Pricing Model (CAPM) or Dividend Discount Model (DDM). – Cost of Preferred Stock (Rp): If a company has preferred stock, its cost is included in the WACC calculation. It is the dividend rate paid to preferred shareholders. – Tax Rate (Tc): The effective corporate tax rate is considered to calculate the after-tax cost of debt.
Calculation
The formula for calculating WACC is:
Where: – WACC: Weighted Average Cost of Capital – E: Market value of the company’s equity – D: Market value of the company’s debt – P: Market value of preferred stock – V: Total market value of the company’s capital (E + D + P) – Re: Cost of equity – Rd: Cost of debt – Rp: Cost of preferred stock – Tc: Corporate tax rate (if applicable)
Significance and Use
– Investment Decision: WACC is used to determine the minimum return required for an investment or project to be considered financially viable. If the expected return from an investment exceeds the WACC, it is generally considered a good investment. – Capital Budgeting: Companies use WACC to evaluate capital budgeting decisions, including mergers and acquisitions, new projects, and expansions. – Valuation: WACC serves as the discount rate in financial valuation models such as the Discounted Cash Flow (DCF) analysis. It helps estimate the present value of future cash flows. – Cost of Capital: WACC provides insight into the cost of raising capital from various sources, including debt and equity. – Shareholder Value: Minimizing WACC can increase shareholder value by reducing the cost of capital and improving returns on investments.
Limitations and Considerations
– Assumptions: WACC relies on several assumptions and estimates, including the cost of equity, cost of debt, and capital structure. Small changes in these inputs can significantly impact the WACC. – Risk Factors: Different industries and companies have varying levels of risk, affecting their cost of capital. Estimating the right discount rate is crucial. – Market Conditions: WACC can change over time due to fluctuations in interest rates, market conditions, and company financial performance. – Complexity: Calculating WACC accurately can be complex, especially for multinational corporations with diverse capital structures. – Use with Caution: WACC is a valuable tool but should be used in conjunction with other financial metrics and qualitative factors for comprehensive decision-making.
Examples
– Project Evaluation: A company considering a new project calculates its expected cash flows and compares them to the WACC. If the project’s expected return is higher than the WACC, it is a favorable investment. – Company Valuation: An investor estimating the value of a publicly traded company uses WACC as the discount rate in a DCF analysis. – Mergers and Acquisitions: In M&A transactions, acquirers evaluate the target company’s financial health and potential returns by considering the WACC. – Debt Issuance: When a company issues bonds, it assesses the market’s interest rates to determine if the cost of debt is lower than the WACC. – Investor Decision: An individual investor may compare the expected return from a stock investment to the company’s WACC to make investment decisions.
The cost of debt can be defined as the amount of interest a firm has to pay over the borrowed capital. In other words, each time a firm borrows a sum of money, within some days, months or years the firm will have to pay back what is called the principal plus interests.
For instance, I borrow $1,000 at 10% simple annual interest due in one year; after one year I will have to pay back the $1,000 (principal) plus $100 (interests).
Now you may wonder what determines the interest payment? Solvency. How to measure solvency? Of course, you can logically understand that a company that is more reliable will also be perceived as safer.
Thus it will able to borrow money at a lower cost, therefore pay lower interests. Yet this can be an explanation sufficient for the laymen, not the financial manager. Let’s take a look at how debt affects both balance sheet and income statement:
From the picture above you can see that under the liability section of the balance sheet we have two forms of debt: short and long-term debt and they both produce interests.
These interests will be paid with the portion of income that is left after paying the operating expenses, which in finance lingo is called EBIT (earnings before interests and taxes).
When the EBIT is a few times greater than the interest expenses, this is a good sign. For instance, a firm that has a monthly EBIT of $1,000 and has to pay $100 in monthly interest expenses, it means that the EBIT is 10x the interest payments (1,000/100), making such firm very reliable.
In financial jargon, this is called the Interest Coverage Ratio (EBIT/Interest Expense), and this measure helps us in the assessment of the credit condition of the company.
Therefore, the higher the interest coverage ratio, the better the credit conditions of the firm, the lower the interests the firm will pay on its debt. I would call this the “debt positive spiral:”
A higher interest coverage ratio determines a lower cost of financing. This, in turn, brings a higher EBIT in comparison to interest expenses, therefore an interest coverage ratio improvement and so on, up to the point in which the interest rates the company pays on its debt get very close to the risk-free rate.
This positive spiral happens when a company is using an optimal capital structure, but when the debt gets out of hand, we have the opposite scenario, the “debt negative spiral:”
In this scenario a lower interest coverage ratio determines higher interest rates on debt financing, which in turn will increase the interest expenses, thus making them grow faster than the EBIT, therefore determining a lower interest coverage ratio and so on, up to the point in which the firm goes bankrupt.
Hot to Measure the Interest on Debt or the Cost of Debt
The interest that a firm pays on the borrowed capital can be defined as its cost of debt. In part this interest is determined by how reliable a company is.
On the other hand, there is a part of this interest that cannot be determined by the organization’s balance sheet, but from other factors. Let’s see below what the interest on the debt is comprised of:
As you can see from the image above the primary building blocks of the interest on the debt are the risk-free rate and the spread.
The risk-free rate is the rate returned by an asset that carries no risk at all, such as the U.S. Treasury bill.
On the other hand, the spread has two primary layers: the country and the company spread. In this specific case, I am referring to corporate debt.
Furthermore, if we want to know the cost of debt for a company that operates in Italy, we must start from the risk-free rate, and eventually add up the country spread and the company spread, this is how we get the cost of debt financing for that firm.
Let’s say that we want to compute the cost of debt for Fiat Chrysler Automotive Group, what do we need to know? We can do that in three steps:
Find out the risk-free rate. Keep in mind that FIAT is an Italian company, thus instead of using the U.S. Treasury Bill as the risk-free rate, we will have to find the European equivalent of it.
Find out the Italian country spread, or the difference between the risk-free rate asset and the long-term Italian bond.
Find out FIAT’s credit rating, which will allow us to determine the company spread.
See the three steps below:
As you can see from the image above, in the first step we determined the risk-free rate. Since Fiat Chrysler Group is headquartered and principal operations in Italy we cannot we had to find the European equivalent of the U.S.
In the third step, I looked up at the rating for FIAT Group, and according to that, I looked at the table to determine the company’s spread based on its credit rating, which turned out to be 3.61%.
Eventually, I determined a cost of debt for FCA Group of 5.16%. This means that FCA Group has to pay at least 5.16% to its creditors to issue a 10-year corporate bond.
Cost of Equity and CAPM
When the investor or equity holder places his money in a venture, he will expect a certain return that we computed through the CAPM, and that is how we determined the cost of equity.
In finance, the capital asset pricing model (or CAPM) is a model or framework that helps theoretically assess the rate of return required for an asset to build a diversified portfolio able to give satisfactory returns.
The same principle applies to the financing decision; we will use the CAPM as the primary framework to assess that cost of equity.
Is WACC reliable?
The main issue with WACC is its underlying assumptions. Since WACC uses the CAPM to assess the cost of capital. Within the CAPM there is a variable called Beta.
Beta, in theory, measures the volatility of a stock, compared to a portfolio by using a standard measure called variance. There are two major drawbacks here.
First, to compute the Beta, we take the historic data of stocks and project it forward, as if, the past can predict the future.
In addition, measures like Beta, start from a distribution, which is called Gaussian, which assumes that we live in a linear world. Thus, generating a huge bias within this metric, and making it worthless, in some instances.
Third, the Beta is considered fixed for a certain period of time, however, the way assets “behave” on the market, and how they are correlated to each other, might change, quickly, and from time to time, according to the context of the market.
In other words, those who use WACC, need to be aware of the major drawbacks this method brings with it.
The problem is, though, that many financial experts, still use the WACC to create financial models, that evaluate companies. Those financial models, eventually, have no real value, because the underlying method is very very biased.
Thus, it might be much more solid, and rigorous to use simpler metrics, like ratios, to evaluate companies, and the cost of capital, rather than relying on WACC, CAPM, and Beta.
Key Highlights
Weighted Average Cost of Capital (WACC): The cost of capital, considering the weighted average of equity and debt in a company’s capital structure.
Importance of Knowing Cost of Debt, Equity, and Capital: Understanding the cost of debt and equity helps assess the profitability and viability of investments, while the cost of capital is essential for discounting future cash flows.
Cost of Debt: The interest paid by a firm on borrowed capital, influenced by the firm’s solvency and creditworthiness.
Interest Coverage Ratio: A measure of a firm’s credit condition, indicating the multiple of earnings before interest and taxes (EBIT) to interest expenses.
Debt Positive Spiral: When a higher interest coverage ratio leads to lower interest rates, resulting in increased EBIT and further improvement of the coverage ratio.
Debt Negative Spiral: A scenario where a lower interest coverage ratio leads to higher interest rates, causing interest expenses to grow faster than EBIT and potentially leading to bankruptcy.
Components of Cost of Debt: Comprised of the risk-free rate, country spread, and company spread, which determine the cost of debt financing.
Cost of Equity and CAPM: The cost of equity is calculated using the Capital Asset Pricing Model (CAPM), which assesses the required rate of return for an asset in a diversified portfolio.
Reliability of WACC: WACC is commonly used but has drawbacks, including assumptions based on historical data, Gaussian distribution bias, and fixed Beta values, which may make it less reliable in some instances. Simpler metrics like ratios could be more solid alternatives for evaluating companies and the cost of capital.
Related Frameworks, Models, or Concepts
Description
When to Apply
Cost of Equity
The Cost of Equity is the rate of return required by investors to compensate for the risk of investing in a company’s equity. It represents the opportunity cost of equity capital and is calculated using models such as the Capital Asset Pricing Model (CAPM), Dividend Discount Model (DDM), or Bond Yield Plus Risk Premium Approach.
Apply the Cost of Equity to determine the required rate of return for equity investors, reflecting the risk and return expectations associated with investing in the company’s stock. Use it as a component of the Weighted Average Cost of Capital (WACC) to calculate the cost of equity financing for investment appraisal, valuation, and capital budgeting decisions.
Cost of Debt
The Cost of Debt is the effective interest rate paid by a company on its debt capital, including bonds, loans, and other forms of borrowing. It represents the cost of borrowing funds and is calculated based on the interest rate paid to lenders, adjusted for taxes and other financing costs.
Apply the Cost of Debt to determine the cost of borrowing for a company, reflecting the interest expense associated with servicing its debt obligations. Use it as a component of the Weighted Average Cost of Capital (WACC) to calculate the cost of debt financing for investment appraisal, valuation, and capital budgeting decisions.
Weighted Average Cost of Capital (WACC)
The Weighted Average Cost of Capital (WACC) is the blended cost of equity and debt capital used by a company to finance its operations and investments. It represents the minimum rate of return required by investors to compensate for the risk of investing in the company’s capital structure. WACC is calculated as the weighted average of the cost of equity and cost of debt, adjusted for the proportion of equity and debt in the company’s capital structure.
Apply the Weighted Average Cost of Capital (WACC) to evaluate the overall cost of capital for a company, reflecting the combined cost of equity and debt financing. Use it as a discount rate for investment appraisal, valuation, and capital budgeting decisions to assess the feasibility and profitability of projects, acquisitions, and other investment opportunities.
Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) is a financial model used to calculate the expected return on an investment based on its systematic risk, as measured by beta, and the risk-free rate of return and market risk premium. CAPM helps determine the required rate of return for equity investors and serves as a key input in estimating the cost of equity capital for WACC calculation.
Apply the Capital Asset Pricing Model (CAPM) to estimate the cost of equity capital for a company, reflecting the risk and return expectations associated with investing in its stock. Use it as a component of the Weighted Average Cost of Capital (WACC) to calculate the overall cost of capital for investment appraisal, valuation, and capital budgeting decisions.
Debt-to-Equity Ratio
The Debt-to-Equity Ratio is a financial metric used to measure the proportion of debt financing relative to equity financing in a company’s capital structure. It indicates the extent to which a company relies on debt capital to finance its operations and investments, with higher ratios indicating higher financial leverage and risk.
Apply the Debt-to-Equity Ratio to assess a company’s capital structure and financial leverage, comparing its debt obligations to its equity base. Use it to evaluate the risk profile and solvency of the company, determine the optimal mix of debt and equity financing, and make decisions about capital structure management and financing strategies.
Modigliani-Miller Theorem
The Modigliani-Miller Theorem is a financial theory that states that in a perfect market with no taxes, bankruptcy costs, or information asymmetry, the value of a firm is unaffected by its capital structure. It suggests that the cost of capital remains constant regardless of the proportion of debt and equity financing used by a company.
Apply the Modigliani-Miller Theorem to understand the relationship between capital structure and firm value, recognizing the theoretical principles underlying the determination of the Weighted Average Cost of Capital (WACC). Use it as a conceptual framework for analyzing capital structure decisions, assessing the impact of financial leverage on the cost of capital, and optimizing the overall cost of capital for a company.
Adjusted Present Value (APV)
The Adjusted Present Value (APV) is a valuation technique used to assess the value of a company by separately discounting the cash flows associated with equity and debt financing. APV incorporates the tax benefits of debt and other financing benefits or costs to determine the total enterprise value.
Apply the Adjusted Present Value (APV) method to evaluate the value of a company by considering the cash flows associated with equity and debt financing separately. Use it as an alternative approach to traditional discounted cash flow (DCF) analysis, particularly when analyzing companies with complex capital structures or significant tax shields, to assess the impact of financing choices on firm value and WACC.
Pecking Order Theory
The Pecking Order Theory is a financial theory that suggests that companies prefer internal financing sources, such as retained earnings, over external financing sources, such as debt or equity issuance. It posits that companies follow a hierarchical order of financing preferences based on the cost, availability, and flexibility of funding options.
Apply the Pecking Order Theory to understand the financing behavior of companies and the factors influencing their capital structure decisions. Use it to analyze the trade-offs between internal and external financing sources, assess the implications for the cost of capital and financial performance, and develop financing strategies aligned with business objectives and market conditions.
Risk-Free Rate of Return
The Risk-Free Rate of Return is the expected return on an investment with zero risk of default, typically represented by the yield on government securities, such as treasury bills or bonds. It serves as a benchmark for determining the risk premium and required rate of return for other investments, including equity and debt securities.
Apply the Risk-Free Rate of Return as a key input in financial models and valuation techniques, such as the Capital Asset Pricing Model (CAPM), to estimate the cost of equity and discount rates for investment appraisal and valuation purposes. Use it as a reference point for assessing the risk and return characteristics of different investment opportunities and determining the appropriate compensation for risk-taking in financial decision-making.
Market Risk Premium
The Market Risk Premium is the excess return demanded by investors for bearing the systematic risk of investing in the overall market, over and above the risk-free rate of return. It reflects the compensation investors require for accepting market risk and serves as a key component in calculating the required rate of return for equity investments.
Apply the Market Risk Premium as a component of financial models, such as the Capital Asset Pricing Model (CAPM), to estimate the cost of equity and determine the appropriate risk premium for equity investments. Use it to assess the relative attractiveness of investing in stocks versus risk-free assets, adjust discount rates for investment appraisal and valuation purposes, and make informed decisions about portfolio allocation and asset pricing.
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country.
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.
Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.
The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both.
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.
A profitability framework helps you assess the profitability of any company within a few minutes. It starts by looking at two simple variables (revenues and costs) and it drills down from there. This helps us identify in which part of the organization there is a profitability issue and strategize from there.
The Triple Bottom Line (TBL) is a theory that seeks to gauge the level of corporate social responsibility in business. Instead of a single bottom line associated with profit, the TBL theory argues that there should be two more: people, and the planet. By balancing people, planet, and profit, it’s possible to build a more sustainable business model and a circular firm.
Behavioral finance or economics focuses on understanding how individuals make decisions and how those decisions are affected by psychological factors, such as biases, and how those can affect the collective. Behavioral finance is an expansion of classic finance and economics that assumed that people always rational choices based on optimizing their outcome, void of context.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
