Understanding the weighted average cost of capital, or the cost of capital, is both a business calculus and an economic term. It’s a term to describe the relationship between two key economic components – equity and debt, as a financial ratio.
Properly formulated, the weighted average cost of capital, or WACC, merges a business’s cost of capital across financial components. Once weighted for proportional balance, WACC bundles all company financial sources (with an emphasis on equity and debt) and adds them together.
The final figures represent the current value of a company, or a project or initiative undertaken by a company.
What Is WACC?
The WACC is the rate that a company must pay, on average, to finance its operations. It’s a figure that business leaders use to make strategic decisions, and a data point used by investors as part of their fundamental analysis of a company.
In general, a low weighted average cost of capital shows that a business is in good financial health and can more efficiently and economically pay for company operations, either through debt financing or equity financing. Earnings are robust enough to curb company debt loads and offer solid investment returns to market investors, which should increase capital to the company.
A higher weighted average cost of capital suggests the opposite outcome. The firm is likely paying more to handle their debt and paying more to raise capital for company projects. That scenario can lead to a business with a lower valuation with less demand from investors to buy company stock or invest in its bond issues, as returns on those investments would likely be lower.
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What is the WACC Formula?
The calculation used for WACC includes cost of equity and cost of debt, along with additional economic components commonly used by businesses.
Here is how those components are broken down in a WACC formula.
• E = Market value of the business’s equity
• V = Total value of capital (equity + debt)
• Re = Cost of equity
• D = Market value of the business’s debt
• Rd = Cost of debt
• T = Tax rate
Once you have those numbers, here’s how to calculate WACC:
WACC = (E/V x Re) + ((D/V x Rd) x (1-T))
To use the WACC formula, you need to first multiply the costs of each financial component and include that component’s proportional rate. Once you’ve arrived at those figures, multiply them by the company’s corporate tax rate. The resulting figure gives you the company’s weighted average cost of capital.
There’s one caveat on calculating the weighted average cost of capital. The formula heavily relies on the cost of equity in its equation, which is largely unknown, since that value can vary. A company’s share capital depends on what the market (i.e., investors) are willing to pay to invest in the company, as exhibited by the company’s stock price.
Given that unknown scenario, companies must evaluate the expected return of their stock, through an investor’s eyes. That represents the value of the company’s equity and any effort to hide or diminish that value could put a damper on a company’s share price.
That’s why companies factor the estimated cost of equity into the WACC equation – they view the cost of equity as the amount of capital a company needs to spend to maintain a stock price that’s largely acceptable to market investors.
An Example of the WACC at Work
For a good look at a company’s weighted average cost of capital, let’s say ABC Company has an annual return of 15% and an average cost of 5% annually to pay for operations. That dynamic represents a 10% profit on its investment in the company.
From an investor’s viewpoint, that same profit scenario represents 10 cents of every dollar invested in the company. That’s 10 cents of capital a business can use to either invest back into the company or can be used to pay down company debt.
On the other end of the equation, if XYZ Company generates an annual investment return of 10% yet owns an average annual cost of capital of 15%, that company is down 5 cents on each dollar invested in the company.
In that scenario, XYZ Co. is in a bind no company wants to be in – its costs of doing business exceed its investment returns. That translates into fewer investors until the firm realigns its financing picture, cuts debt, and gives investors a good reason to buy its stocks and bonds.
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Why the Need for Weighted Average Cost of Capital?
The weighted average cost of capital breaks down a firm’s cost of doing business by weighing the debt (including bonds and other long-term debt) and equity structure (including the cost of both common and preferred stock) of the company.
Primarily, companies need to finance their operations in three ways:
1. Debt financing
2. Equity financing
3. A combination of debt and equity
No matter which option a company chooses, sources of capital come with a financial cost.
The WACC seeks to find the “true cost of money” in operating a business by comparing the cost of borrowing of capital to run a company versus raising capital through equity to pay for common business needs like property and equipment, research and development, human capital (i.e., employees), and business expansion, among other costs.
When company executives know the WACC, they can leverage that financial ratio to decide on funding the firm through debt or equity financing. The cost of equity will depend on the value of the company’s stock, while the cost of debt will reflect interest rates.
Basically, companies require an accurate weighted cost of capital to properly weigh expenses and provide fair cost of analysis on projects in the pipeline. Additionally, companies can leverage their WACC to evaluate their capital structure and weigh the myriad financial sources needed to fund operations, proportioned accurately.
Using one form of capital to fund a company’s operations makes the cost of capital formula fairly simple. However, when companies use multiple forms of capital the formula becomes more complicated and requires financial modeling.
The weighted average cost of capital is not exactly a precise measurement of a company’s financial health, but it can be a highly useful one, especially for investors.
The data is easily found in a publicly-traded company’s balance sheets, which are made available to investors on a regular basis. Just visit the company’s web site, locate its financial information page, and look for the relevant data.
If you’re ready to use this data and other information to start building a stock portfolio, a great way to get started is by opening an account with the Sofi Invest® brokerage platform. If you’d prefer not to take a hands-on approach to investing, you can also use the automated investing option for the account, an algorithm will suggest an appropriate mix of investments based on your age and retirement goals.
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