What Is The Weighted Average Cost of Capital? WACC in a Nutshell

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: $WACC Formula$ 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.

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Table of Contents

What is the cost of debt?

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.

Treasury Bond. In fact, I took the 10-year rate for the German Bond (called Bund), which rate is 0.29%.

Furthermore, in the second step, I took the 10-year spread between the German bund and the Italian BTP (BTP is the equivalent of the American bond), which is 1.26%.

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.

capital-asset-pricing-model — 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.