You may recall from our valuation methodology or time value of money blog posts that our primary valuation technique – the Discounted Cash Flow (DCF) method – relies on a Discount Rate. Although there are good reasons to use (or at least test!) other rates, the appropriate Discount Rate to use for a DCF is often the company’s weighted average cost of capital or “WACC”.
Understanding WACC: Let’s Break it Down
Companies have various options available to them when it comes to funding their operations. From debt, such as taking out loans or offering long-term corporate bonds, to equity in the form of stock, companies need to find a balance between these options that gives them the best possible cost of capital. This, in turn, will help them to finance their operations as cheaply as possible.
WACC is a measure of what these capital inputs or financing options will cost the company in terms of an average interest rate for the whole business. The weights refer to the different percentages that make up each type of financing in the company's capital structure.
Why is it important for a company to know its WACC?
Knowing your company’s WACC helps you estimate how expensive it will be to fund projects in the future. The lower your company's WACC, the cheaper it will be to fund new projects.
For example, if it will cost an organization 7% in capital costs to fund a project that creates 10% in profit, then it can confidently raise capital to fund this project. If the project would only return 6%, it’s easy to argue against going ahead with the new project, as the return on investment would not justify the cost of funding it. Indeed, as a general rule, if a project or initiative returns more than a company’s WACC, it should pursue the project – so knowing your WACC is critical to strategic decision making.
The basic formula to calculate a company’s WACC may look complicated, but the calculations themselves are actually quite simple – it is just doing a “weighted average” calculation on all your sources of capital. The WACC formula is:
WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)]
E = Market value of the company's equity
D = Market value of the company's debt
V = Total Market Value of the company (E + D)
Re = Cost of Equity
Rd = Cost of Debt
T= Tax Rate
Here’s an example to explain:
Imagine that a manufacturing business is thinking about building a new factory, for which it will need to raise $1 million in capital. The company knows that it can raise $800,000 from its bank at a 12% interest rate, but that the bank also requires an equity contribution from the company for the balance of $200,000. The shareholders of the company, who put $100,000 of equity in the company to start it up originally, are willing to inject this $200,000, but expect to earn a 25% return on their equity.
The company’s total market value is therefore ($100,000 original equity + $200 000 new equity + $800,000 debt) = $1.1 million. Assume its corporate tax rate is 35%. Now we have all the ingredients to calculate WACC:
WACC = (($300,000/$1,100,000) x 25%) + [(($800,000/$1,100,000) x 12%) * (1-35%))] = 0.12491 = 12.5%
The WACC is therefore 12.5%.This means that for every $1 the company raises under the capital structure above, it must pay its investors almost $0.13 in return. It also establishes a very useful threshold to inform the strategic decision to build a warehouse in the first place – unless the company believes the warehouse will generate returns above 12.5%, it should not build it in the first place (or, it should seek out cheaper sources of capital to reduce WACC, thereby making the project more attractive).
Knowing your company’s WACC is therefore an important marker in justifying the potential costs of funding a new project. This can be helpful for both the shareholders within the business, and potential external funders, as their expectations can be managed and return on investment more accurately forecasted.
And, tying back to valuation, not only can WACC be used to evaluate new project or investment opportunities for the company, because it represents the cost (or “riskiness”) of the company’s future cash flows, it importantly serves as the Discount Rate for DCF valuation purposes.