A company's weighted average cost of capital (WACC) is the blended cost a company expects to pay to finance its assets. It's the combination of the cost to carry debt plus the cost of equity.
A high WACC typically signals higher risk associated with a firm's operations because the company is paying more for the capital that investors have put into the company. In general, as the risk of an investment increases, investors demand an additional return to neutralize the additional risk.
Alternatively, a low WACC demonstrates that a company is not paying as much for the equity and debt used to grow its business. Companies with low WACC are often more established, larger, and safer to invest in as they've demonstrated value to lenders and investors. By demonstrating long-term value, the company is able to solicit funding at a lower cost.
Key Takeaways
- WACC is the blended cost a company pays for its debt and equity.
- WACC is used to evaluate the performance of a company. If a company's returns are less than its WACC, the company is not profitable.
- WACC is highly industry-specific, and the calculation garners the most value when compared across similar companies in the same industry.
- WACC is calculated by blending the weighted cost of equity with the weighted cost of debt after considering tax benefits.
- WACC is often used as the discount rate for capital projects, so lower WACC calculations make project profitability easier to achieve.
What is WACC Used for?
A company's WACC can be used to estimate the expected costs for all of its financing. This includes payments made on debt obligations (cost of debt) and the required rate of return demanded by ownership (cost of equity). Most publicly listed companies have multiple funding sources. Therefore,WACC attempts to balance out the relative costs of different sources to produce a single cost of capital figure.
When calculating WACC, the cost that a company pays for capital can include the interest rate it pays on debt, which is the cost of debt, and the dividends it pays to shareholders, which is the cost of equity.
In theory, WACC represents the expense of raising one additional dollar of money. For example, a WACC of 5% means the company must pay an average of $0.05 to source an additional $1. This $0.05 may be the cost of interest on debt or the dividend/capital return required by private investors.
Example of a High Weighted Average Cost of Capital (WACC)
Imagine a newly-formed widget company called XYZ Industries that must raise $10 million in capital so it can open a new factory. The company issues and sells 60,000 shares of stock at $100 each to raise the first $6,000,000. Because shareholders expect a return of 6% on their investment, the cost of equity is 6%. XYZ then sells 4,000 bonds for $1,000 each to raise the other $4,000,000 in capital. The people who bought those bonds expect a 5% return, so XYZ's cost of debt is 5%.
The WACC combines the cost of both the equity and debt funds. Assuming a 10% tax rate, the company's WACC is:
WACC = (Cost of Debt * Weight of Debt * (1 - Tax Rate)) + (Cost of Equity * Weight of Equity)
WACC = (5% * 40% * (1 - 10%)) + (6% * 60%)
WACC = 5.4%
Let's say the company evaluates that the projected annual return of the new factory will only be 3%. Because the WACC is higher than the expected return of the project, the project will not be profitable as the amount earned from the factory does not exceed the cost of sourcing funds to build it.
Why Does WACC Matter?
WACC is an important consideration for corporate valuation in loan applications and operational assessment. Companies seek ways to decrease their WACC through cheaper sources of financing. Issuing bonds may be more attractive than issuing stock if interest rates are lower than the demanded rate of return on the stock.
WACC By Sector
WACC is highly dependent on the company's industry and nature of business. For example, real estate companies can often provide greater collateral for lower financing costs. Small technology firms often rely heavily on private investments at often higher upfront costs. Financial firms carry debt as part of their operations, so the WACC is less useful. Ensure you compare the WACC across similar companies to garner the best value from this calculation.
There is often a law of diminishing returns associated with financing sources. For example, imagine the company in the prior example raised the first $6 million by borrowing funds. Then, it evaluated how to raise the other $4 million and considered incurring more debt. Because its risk profile is now higher from the initial $6 million, it may now be more expensive to incur more debt.
Value investors might also be concerned if a company's WACC is higher than its actual return. This is an indication the company is losing value, and there are probably more efficient returns available elsewhere in the market.
Balance Sheet
Parts of a WACC are pulled from the balance sheet. Since the WACC evaluates the cost to finance all assets, the formula uses "Total Liabilities" and "Market Value of Equity".
Taxes can be incorporated into the WACC formula, although approximating the impact of different tax levels can be challenging. One of the chief advantages of debt financing is that interest payments can often be deducted from a company's taxes, while returns for equity investors, dividends or rising stock prices, offer no such benefit. Therefore, two different companies with the exact same debt-to-equity ratio may have varying WACC calculations if they have different levels of profitability.
What Is a Good Percentage for WACC?
WACC varies across industries. In addition, younger companies will often have higher WACC as they are riskier and must entice investments or incur debt at higher costs. In general, lower WACC calculations represent safer companies.
What Does WACC Indicate?
WACC indicates the blended cost a company is paying on its debt and equity. It is often used as the benchmark to gauge whether operations or projects are successful. If the WACC exceeds the company's returns, the company is paying more to investors than it is earning.
How Do You Calculate WACC?
WACC is calculated by merging the weighted cost of equity with the weighted cost of debt (after factoring in tax benefits:
WACC = (Cost of Debt * Weight of Debt * (1 - Tax Rate)) + (Cost of Equity * Weight of Equity)
The Bottom Line
Weighted average cost of capital is an integral part of a discounted cash flow valuation and is a critically important metric to master for finance professionals. WACC is heavily used in corporate finance and investment banking roles, and it often sets the benchmark return a company must strive for.
