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Weighted Average Cost of Capital (WACC) and Its application in finance

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Weighted Average Cost of Capital (WACC) and Its application in finance

The first and foremost condition to carry out any economic activity is that it should be financially viable. Financial viability is when the project earns a return in excess of its cost of capital. Capital could be raised via Equity and Debt, but neither is costless. So before putting money into any investment project, it is necessary to know the costs associated with the capital required for its funding.

Cost of capital is the weighted average of costs of different sources of capital viz- Equity and Debt. The cost of capital turns into a minimum required rate of return when analyzing a proposed investment; it acts as a discount rate while performing the valuation of financial assets.

Here, we will understand the fundamentals and calculations of the Cost of Equity, Cost of debt, and Combined cost of capital, known as the Weighted average cost of capital (WACC).

Cost of equity (Ke)

Equity is the residual claim over the cashflows of a business. After payment is made to all other sources of capital, whatever is remaining belongs to equity holders. In return for their residual claim, equity holders get the status of an owner in a business, and they enjoy control over the company’s affairs.

The capital asset pricing model (CAPM) is the most widely used method to determine the cost of equity. CAPM assumes that marginal investors in a company are diversified, which causes the company-specific risk to get eliminated, and only Systematic risk remains to get priced in the market; systematic risk is the risk that affects all the companies.

CAPM builds on this theory and computes “Beta,” which measures systematic risk on a relative basis, i.e., relative to the overall market or an average risky company. For example, suppose the Beta for a given company is 1.5. In that case, it means that the given company is 1.5 times riskier than the overall market or the average risky stock in the market.

Now once a standardized measure of systematic risk is established cost of equity can be computed using the following equation:

Ke = RF + β x ERP

Where,

RF: RF is the Risk-free rate, i.e., the rate of return investors expect to make by investing for the long term without exposing themselves to any default or reinvestment risk. Long-term treasury rates can be taken as a proxy for Rf. For countries with sovereign ratings lower than AAA, an adjustment for sovereign spread should be made in treasury yields.

ERP: ERP refers to Equity risk premium, i.e., the return of the overall equity market over and above the risk-free rate. ERP can be computed as the difference between historical equity market return and risk-free rate – known as historical ERP, or it could be taken as the difference between consensus expected equity market return and current risk-free rate – known as Implied ERP. Implied ERPs should be preferred over their historical counterpart as they reflect current market dynamics better.

Beta (β): As defined earlier, Beta is a measure of relative systematic risk that is standardized around one. The overall market or average risky company has a beta of 1. A beta that is higher than one is considered above average and relates to a higher-than-average risky company and vice versa. Beta can be computed by regressing the stock returns of the subject company against the returns of the overall market (or a market index such as the S&P 500 acting as a proxy of the overall equity market). For private companies where Stocks are not traded, and return data is unavailable, an approach called the “Pure play method” can be used. In the pure play method, an average of asset betas of similar public companies are computed. Then the average asset beta is relevered to reflect the subject company’s debt-equity mix.

The calculation process of Cost of Equity can be understood better by the following example:

Name of the CompanyXYZ Inc.
Risk-free rate (Rf)4%
Implied return of Equity market9%
Beta for XYZ Inc.1.4

Using the CAPM equation Cost of Equity is determined as:

Ke = Rf + β x ERP

Ke = 4% + 1.4 x (9% – 4%)

Ke = 11%

Cost of debt (Kd)

Apart from Equity, Debt is the other source of capital. Debt is a contractual and priority claim over a company’s cashflows. It is a legal liability of the company to pay interest and repay the principal to debtholders whenever due. Otherwise, debtholders can bring about bankruptcy for the company. Debt holders enjoy a priority claim; they are first in the line to get paid; only after their interest is satisfied that payment is made to other sources of capital. Because of these features, debt is considered less risky than equity and has a lower cost.

The cost of debt can be computed as a weighted average of the costs of different debt issues presented in the balance sheet. For each case, its current Yield to maturity (YTM) can be considered the cost of debt. However, the biggest challenge to this method is the illiquidity of the bond market, a big chunk of the bond market is over the counter (OTC) market, and not all bond issues trade regularly, so current YTM is not readily available, apart from this presence of bank debts also create challenges as bank debt are not traded at all.

So, the cost of debt can be computed using a built-up method. A risk-free rate is taken as the base, and appropriate adjustments are made to arrive at the company’s cost of capital. These adjustments are Country default spread, aka Sovereign spread, spread based on the sovereign rating of the country where the subject company is located, and adjustment for Company default spread, spread based on the corporate family rating (CFR) for the subject company. Cost of debt calculations can be understood with the following example:

Name of the Company

XYZ Inc.

Risk-free rate

4%

Sovereign Rating (By Moody’s)

Baa1

Corporate family rating (CFR)

Aa1

Spread based on Sovereign rating (Sovereign spread)

1.92%

Spread based on CFR (Company default spread)

0.48%

Pretax Kd = RF + Sovereign Spread + Company default spread

Pretax Kd = 4% + 1.92% + 0.48%

Pretax Kd = 6.40%

6.40% is the pre-tax cost of debt; it can be made after-tax using a marginal tax rate (t). If we assume the marginal tax rate to be 35%, then the post-tax cost of debt would be:

Kd = Pre-tax Kd x (1-t)

Kd = 6.40% x (1 – 35%)

Kd = 4.16%

Weighted average cost of Capital (WACC)

The weighted average cost of capital is the combined cost of all sources of capital (Debt and equity). WACC can be computed using the following equation:

WACC = Ke x We + Kd x (1-t) x Wd

Where,

We: Weight of equity in the capital structure.
Wd: Weight of Debt in the capital structure.

where We + Wd should be equal to 100%

Continuing the above inputs, if we assume the capital structure of XYZ Inc. to be consisting of 60% equity and 40% debt, we get WACC as follows:

WACC = 11% x 60% + 6.40% x (1-35%) x 40% = 8.26%

Uses of WACC
Cost of capital is a very widely used metric in Economics & Finance. Its uses consist of the following.

  • Project evaluation: In evaluating a capital budgeting project, the cost of capital is an essential input. Whether evaluation is carried out using the Net present value (NPV) approach or Internal rate of return (IRR) approach, Cost of capital is required. In the NPV approach, WACC acts as the discount rate for the computation of present values of expected future cash flows of the proposed project; in the IRR method, the cost of capital is compared with the project IRR to decide whether to accept or reject it.
  • Securities valuation: For computing Enterprise value (EV) for a company using the Discounted cash flow (DCF) analysis technique, WACC act as a discount rate that is used to compute present values of future cash flows.
  • Mergers & Acquisitions: In Mergers & Acquisition (M&A) transactions, the valuation of the target is determined to know its true worth, which helps finalize the purchase price. In Valuing the target, WACC plays an important role when valuations are performed using the DCF technique.
  • Performance evaluation of Fund managers: WACC plays a vital role in the performance evaluation of fund managers. Their actual portfolio returns are compared with the WACC (in this context, WACC is called the required rate of return) to compute what is known as Jensen’s alpha.
  • Analyzing investments: Whether an investment, e.g., a decision to invest in a company’s stock, is justified or not can be judged by comparing its actual returns with a required rate of return (WACC).
  • Deciding on the ideal Debt-Equity mix: How much debt a company should have in its capital structure is an important question to answer. Ideally, the capital structure should be such that it minimizes the WACC for the firm, thereby maximizing its valuation. So, deciding upon how much debt is the ideal WACC is a critical analysis input.

Conclusion

The WACC is an essential financial metric used in various places in economics & finance for evaluation purposes. Its computation is subjective and should consider the company, economy, risk factors, etc., and facts and requirements of each case. For what other purposes is WACC used in finance? Share your thoughts.

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