Understanding WACC (Weighted Average Cost of Capital)
Written by Team 365 finance
You may have started a business because you’re passionate about a certain industry or found a gap in the market for a new product. Not many people start a business because they love the financial side of things.
However, business owners will very quickly realise that even with a great accountant and financial advisor, they still need a good grasp of financial knowledge and calculations to confidently make internal decisions, explore expansion opportunities and understand their company’s financial health.
One of those important calculations is WACC (aka Weighted Average Cost of Capital).
WACC is essentially the average cost you pay to use investors’ money to finance your business. It’s an important number to help you make business decisions: the lower the cost, the less risky a decision is.
In this article, we’ll break down what WACC is, why it’s important and how to calculate WACC to help guide your business decisions.
Breaking Down WACC
WACC is made up of three components: the cost of equity, cost of debt and capital structure:
Cost of equity
This is the total return you’ll need to generate to compensate investors for the risk of their investment. To calculate this figure, business owners will commonly use the Capital Asset Pricing Model (CAPM) and the Dividend Discount Model (DDM).
This cost isn’t always the easiest to calculate, as shares don’t always have a specific value or price, so an estimate is good enough. Also, remember the tax deduction you get on interest paid on debt; this should also be accounted for in your calculations.
Cost of debt
This cost is a little easier to calculate as it’s just the interest rate subtracted from the amount your company owes in debt. Since interest payments are often tax-deductible, the after-tax cost of debt is used in the WACC calculation.
Capital Structure
Finally, capital structure is the proportion of your company’s financing that comes from debt and equity. For example, a company with more debt would have a higher debt-to-equity ratio.
How to Calculate WACC
The WACC formula is:
WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))
Where:
- E = Market value of equity
- D = Market value of debt
- V = Total market value of capital (E + D)
- Re = Cost of equity
- Rd = Cost of debt
- Tc = Corporate tax rate
The formula may look a little scary to begin with but, to put it simply, you’re calculating a weighted average of the cost of equity and cost of debt, based on their proportions in your company’s capital structure.
Why WACC is Important
WACC is an important calculation that’s used by both businesses and lenders to make financial decisions.
For businesses, WACC is a good way to evaluate investment opportunities. For example, if you run a small chain of restaurants and are considering opening up a new location, you should calculate whether the project’s expected return exceeds the WACC figure. If it does, the decision is generally considered to be financially viable.
It’s best to view WACC as a ‘hurdle rate’ or minimum acceptable return on investment; if you are over it, you’re doing good.
On the other hand, investors will use the WACC figure to calculate the opportunity cost of investing in a company and the amount of return they can expect to see.
How to Calculate WACC
Let’s look at an example of calculating WACC for a hypothetical business, broken down step-by-step.
We’ll start with the market value of a company’s debt being £500,000, with a market value of equity at £2,000,000.
The company is a chain of pubs that’s looking for external investment to grow, and the minimum return its shareholders want (cost of equity) is 10%. In this case, E/V = 0.8 (£2,000,000 of equity divided by £2,500,000 total value of capital. So:
Weighted cost of equity = 0.8 x 0.10 = 0.08
Now, we move on to the weighted cost of debt and determining D/V. This comes to 0.2 (£500,000 in debt divided by £2,500,000 total capital). Now multiply this figure by the cost of debt; let’s say it’s 3%. Multiply this number by 1 minus the tax rate (let’s call it 0.25, which means 1 minus Tc is 0.75). So:
Weighted cost of debt = (0.2 x 0.03) x 0.75 = 0.0045
You’ve done all the hard parts of the formula now. To finish off, simply add the two figures and you’ve got your WACC:
WACC = 0.08 + 0.0045 = 0.0845 = 8.45%
Ways to Reduce WACC
If you’ve calculated your WACC and found that your project isn’t considered financially viable, it doesn’t mean that you should give up on your idea – there are three main ways to reduce your WACC:
- Optimise your capital structure to find the right balance between debt and equity.
- Reduce the cost of debt by negotiating lower interest rates, improving credit ratings or diversifying debt sources.
- Reduce the cost of equity by enhancing profitability, improving the relationships with your investors and reducing business risk.
Common Mistakes and Misconceptions
There are a lot of numbers and separate calculations that go into the final WACC figure, so don’t worry if it takes you a couple of tries to get the correct figure. To help ensure you get the right answer, try to avoid some of these common mistakes that companies make and misconceptions they ignore.
- Using book values instead of market values.
- Failing to account for the tax deductibility of interest can result in an overstated cost of debt.
- Ignoring that WACC is a dynamic figure and can change over time depending on market conditions and business strategies. It’s made up of inconsistent values, so different people may report different numbers.
- Misunderstanding the meaning of WACC: a high WACC doesn’t mean your business isn’t performing well, it’s just a higher hurdle you must jump over.
Conclusion and Key Takeaways
In conclusion, WACC is a financial metric that measures the average cost of capital for your business. Whether you’re growing your team or investing in new machinery, this calculation will help you decide whether a certain decision is right for your business at this current time.
Understanding the different components and applications of this calculation is also extremely important if you want to make sound business and investment decisions.
Key takeaways:
✅ WACC shows the cost of a company’s capital from all sources
✅ It should be used to evaluate investment projects
✅ Optimising capital structure and reducing costs of debt and equity can reduce WACC
✅ WACC is a dynamic calculation that can change over time
If you’re looking at external funding to fuel your business’s growth, speak to one of the 365 Finance experts to figure out the best options for you and your business.
Looking to learn more about crucial financial topics like accounting, investing, and loans? Check out the 365 Finance Academy for more educational articles.