In prior editions, I’ve explained some common, straight-forward terms. Today, we take a dive into a more complex idea: Weighted Average Cost of Capital (WACC). While it may sound slightly esoteric, it’s potentially one of the most important concepts both in investing and corporate finance. Investment decisions are made on the basis of WACC; if the return on a project or investment exceeds the WACC, generally it would be expected to proceed; the reverse is also true.
Alternative phrases: Cost of capital, WACC, hurdle rate.
Short explanation: WACC is how much it costs the company, on average, to obtain capital. The cost of debt and the cost of equity are combined using a weighted average to calculate the overall cost of capital.
More detail: Whether you’re a company, an investor, a hedge fund, or an investment bank when considering an investment, a key question is always; “what’s the minimum rate of return required to create value?” The answer is the WACC. The WACC is also widely used as the discount rate in discounted cashflow valuation.
Cost of debt is easy to calculate and simple to understand; based on the current market price of the company’s debt, what interest rate would the company pay to raise more debt today? If the yield to maturity on the company’s bonds is 5%, then this is the cost of debt. A company with debt should disclose their average interest rate paid under Interest Bearing Liabilities in the Notes to the Financial Statements.
Cost of equity is simple in concept but difficult to calculate. It is simply how much it costs the company to raise new equity capital, expressed as a percentage rate. Traditionally, the dividend yield was used in the Dividend Discount Model, but as many companies today (especially in the USA) choose not to pay dividends, this is no longer an ideal model. Today, the industry standard is the Capital Asset Pricing Model (CAPM). Understanding the CAPM is beyond the scope of this article, but this three minute YouTube video covers off the basics.
Once the cost of debt and the cost of equity have been calculated, it’s simply a matter of creating an average based on the current capital structure of the company. For example, if the company’s capital is currently 75% equity and 25% debt, these are the weights used in calculating the average. A hypothetical example is provided below:
Cost of debt = 5%
Cost of equity = 10%
Gross debt as a percentage of total capital: 33.3%
5% x 33.3% = 1.67%
10% x 66.7% = 6.67%
1.67% + 6.67% = 8.34%
The Weighted Average Cost of Capital is 8.34%.
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