What is WACC?

In this post. we are going to discuss what is WACC, how to calculate it and how it can be used by investors and business owners to analyze financial health and performance of the company.

Every company needs funds to operate and expand its business, while some companies are successfully able to fund all their financial requirements using their internal accruals, there are many companies that rely on external sources to fund their business.

There are two ways a company can borrow funds, first, selling a part ownership in business by issuing shares to people via IPO route, second by borrowing funds in the form of debt from banks or issuing bonds.

Every fund comes at a cost, when companies borrow funds via debt they have to pay interest on it. Similarly, when money is raised by equity, company has to make sure that it generates higher returns compared to shareholders expectation.

What does WACC tell you?

As mentioned earlier, WACC is a measure of the cost of fund to a company, weighted by its proportion. By taking weighted average in this way, you can determine the minimum return a company must get from its business in order to pay back its dues and retain some profits as well.

For example, if a company A is funded ₹ 20 by debt at an interest rate of 10% and ₹ 80 by equity at the cost of 12%, the total Weighted Average Cost of Capital will be:

20 × 10% + 80 × 12%

= 2 + 9.6

= ₹ 11.6

So, the minimum return Company A must earn from its business is ₹ 11.6 against every ₹ 100 invested. This minimum return that a company must earn is called hurdle rate.  

If the weightage of the source of fund changes (that is if company dilutes equity to pay off its debt), or if the company borrows more capital from any of the two sources, the weighted average will be changed and new hurdle rate is calculated.      

However, the example mentioned above is a very simplified version of WACC formula as it does not take into account many factors such as tax rates applicable to the company, how cost of equity is calculated.

The weighted Average Cost of Capital (WACC) also takes into account the tax applicable on the company as it is also an expense that the company has to bear.   

Formula for WACC is as follows:

WACC = wD × rD × (1-t) + wP × rP + wE × rE

Where:

w = the respective weight of debt, preferred stock/equity, and equity in the total capital structure

t = tax rate

D = cost of debt

P = cost of preferred stock/equity

E = cost of equity (explain what is cost of equity and how it is calculated)

If the formula look very complex and difficult to understand, just be patient, it’s not as difficult as it looks, once you understand the meaning of each symbol used, the reason and its significance, WACC will become a piece of cake for you.

Dissecting WACC formula:

Let me break up each and every component of the formula and explain each of them in detail:

Weightage of Debt (wD) and Rate of Debt (rD):

The cost of debt refers to the interest rate a company pays on its current debt. A company may borrow capital from various sources, with different interest rates.

Cost of debt takes all the different types of debts with their respective interest rates and calculates the total interest expense incurred by the company. Cost of debt helps companies and businesses understand the overall interest being paid by the companies on every debt.   

For example, if a company has borrowed ₹ 100,000 at a rate of 7%, and issued bonds worth ₹ 500,000 at interest rate of 5% the total interest expense for the company would be (100,000 × 7% = 7,000) + (500,000 × 5% = 25,000)

25,000 + 7,000 = ₹ 32,000 per year.

The total interest expense will be divided by total amount of capital borrowed via debt to calculate the total cost of debt. As per our example the total debt on the company is:

100,000 + 500,000 = ₹ 600,000

The total interest expenses is ₹ 32,000

So, the total cost of debt will be:

(32,000 ÷ 600,000) × 100 = 5.33%

Now, you must be wondering what does the formula with (1-t) with cost of debt mean and why is it there? Let us understand that part.

Tax rate (1-t):

The t in the formula stands for effective tax rate that is applicable to the company.

The reason why we have (1-t) in the formula is because interest paid by the company is treated as business expense and that is why the total tax levied on the company is calculated after deduction of interest expenses.

Since the interest payment is treated as expense and is deductible from the profit of the company, it reduces the effective cost of debt significantly for the company.

For example, if a company has debt at 5%, then its pre-tax cost of debt is 5%, so the annual interest payment for the company is ₹ 5,000.

The company will now claim this this amount as expense and the same will be deducted from the company’s profit, thus bringing down the profit of the company by ₹ 5,000.

Assuming the tax paid by the company is 30% of the income, using the formula (1-t) the total cost of debt after tax would be (1-30%) = 70%. Now 5% of the 70% would be 3.5%, which means that company will have to pay ₹ 3,500 as tax on its income instead of ₹ 5,000 which means the company saves ₹ 1,500.

This is one of the reasons why companies prefer borrowing capital instead of issuing equity shares to shareholders. Also, since the process of equity dilution is costly and time taking, companies prefer borrowing money instead of raising capital.

Cost of Equity (wP × rP + wE × rE):

Before we move towards understanding what is cost of equity and how to calculate it, it is important to understand the types of equity shares and the difference between them.

There are two types of equity shares, preference shares and common equity shares. Preference shares (as the name suggests) are a class of equity where dividends are paid to the shareholders before the common equity holders, most preference shares have fixed dividends. One of the biggest drawbacks of preference shares is that the preference shareholders do not have a voting eight.

Common equity, on the other hand is what you buy and sell from the stock market, the dividends are not fixed and nor regular, when company goes bankrupt, common equity holders get the proceeds left after paying for all the debt obligations and preference shareholders. Common Equity shareholders get voting rights which is equal to the number of equity shares held by them.   

Now, coming back to the cost of equity. Just like debt, even capital raised via equity comes at a cost. When investors invest in a company, they expect some return from their investment.

The return expected from the investment is usually based on many factors such as past earnings growth records of the company, how risky the business is, volatility in the price of the stock and opportunity cost.

The formula above calculates the sum of weighted averages of both preference (wP) and equity shares (wE) and expected returns from each of them ( rP and rE respectively).

The question now is, how do you calculate the expected return from equity? Unlike cost of debt, which is pretty straightforward and easy to calculate, calculating cost of equity can be slightly tricky as there is no concrete formula to calculate the cost of equity that a company must pay. However, that does not mean there is no cost of equity.

There are few basic points you need to keep in mind while calculating cost of equity for WACC, first, there is no fixed formula for calculating cost of equity and that is why, cost of equity can be very subjective.

As a thumb rule, the shareholders’ expected rate of return is considered a cost from the company’s perspective. That’s because if the company fails to deliver this expected return, shareholders will simply sell off their shares, which will lead to a decrease in share price and the company’s overall valuation.

In simple words, the cost of equity is essentially the amount that a company must deliver in order to maintain a share price that will keep its investors satisfied and invested.

Coming to the question, how do you calculate cost of equity? One of the most widely used models for calculating cost of equity is Capital Asset Pricing Model (CAPM).

Capital Asset Pricing Model is a model that establishes relationship between risk and expected return and is widely used for pricing of risky assets like equity.

CAPM is a very important topic, and needs a detailed discussion, for more details, please read investopedia’s article on CAPM:

CAPM uses four different factors to assess the cost of equity which are as follows:

Risk Premium

Volatility of security

Expected return from the market

Expected return from security

Equity is a risky asset class as you may lose your invested capital. In order to compensate for the risk taken by the investor, he expects a higher return, which is called risk premium.

Put simply, risk premium is the difference between return earned from risk free investment (such as Government bonds, bank fixed deposits etc.) and expected return from the market.

Volatility of the security is the measure of the stock’s risk which is reflected in the form of beta, which is the fluctuation in stock price vs the overall market. The market beta is always considered as 1, and if the stock has higher volatility than the market, beta of the stock will be higher than 1, else beta of the stock is lower than one.

Expected return from security is a long term assumption about how an investment in a security is expected to play out over its entire life.

Expected return from the market on the other hand is about how much return an investor can expect if he chooses to invest in broader market index instead of a single security.

How to use WACC?

Having understood the WACC in detail, let’s move on and see how WACC can be used to measure the cost of capital.

For this purpose, we will take a hypothetical example where a company has sourced 20% of its capital from debt at an interest of 8% and rest 80% is sourced from equity at a cost of 12%. The tax applicable is 30% of the income.

Taking all the assumptions, the weighted cost of debt (pre-tax) is 1.6% and post-tax is 1.12%

The total weighted average cost of equity is at 9.6%.

So the total WACC of the company becomes 1.12% + 9.6% = 10.72%.

here is how it looks like:

The question is, how would you know that a company is able to bear this cost of capital and stay profitable? The answer lies in comparing the cost of capital with the total return the company generates over its invested capital.

It’s a common sense that in order to remain profitable, a company must generate returns higher than the cost of capital, the question is, how do you find out how much return a company is generating?

While there are many ratios like ROE and ROCE, that measure the return on investment based on various parameters (I have written a detailed post on ROE and ROCE and how to use them, you can read them by clicking here) , one of the most efficient ratios is the ROIC or Return on Invested Capital.

ROIC measure the return a company generates over the total capital employed. The formula for ROIC is as follows:

ROIC = Net Profit ÷ Total Capital Employed

Where:

Net Profit is the Profit left with the company after paying tax and before paying dividends

Total Capital Employed includes shareholders fund (which is a sum of share capital and Reserves) and total debt on the company.

So if a company has Net Profit of ₹ 100 and the total capital employed including debt and equity is ₹ 700, the ROIC for the company will be 100 ÷ 700 = 14.2%    

If the ROIC of a company is higher than WACC, then we can safely assume that company is able to meet its cost of capital and still retain some profits.

On the other hand, if the ROIC is lower than WACC, it shows that company is unable to meet its cost of capital and may not be able to pay its interest costs, or the shareholder may not be satisfied with the returns from their investment and may sell their stake in the company to invest elsewhere.

Limitations of WACC:

No matter how good any formula may be, it has its own limitations and that is why you must not rely on them blindly.

WACC is no different and has its own set of limitations that you must be aware of before making an investment decision.

Some of the limitations of WACC are as follows:

One of the biggest limitations of WACC is that because certain elements of the formula, such as cost of equity, are based on assumptions, the outcome may differ from person to person.

For example, in the previous example, if we use cost of equity as 11% instead of 12% the WACC will change from 10.72% to 9.92%. As you can see, one small change in assumption can lead to a huge difference in the outcome.

Secondly, WACC is can change with change in the capital structure of the company. If a company decides to take more debt to fund its expansion, the change in capital structure requires WACC to be recalculated taking into account the changes in capital structure.

Conclusion:

Every company wants to maximize returns and minimize its cost to achieve higher profit to stay ahead of their competitors and maximize shareholder value.

Also, investors are keen to know if a company is generating enough returns to meet its cost of funds. WACC is a great way to serve both the purposes.

WACC can be used by investors and shareholders to analyse if the company is generating enough profits to meet its cost of capital and stay profitable.

WACC is a great tool for business owners to find optimal capital structure to maximize profit and minimize cost.