Renowned investor and CEO of Berkshire Hathaway Warren Buffet once admitted one of his worst errors was putting money into USAir in 1989, only for the airline’s losses to spiral as it couldn’t keep its costs down. Several years later, USAir returned around $240m in dividends, but Buffet’s mind was made up; the ride was too bumpy, and he wouldn't repeat the mistake.
The lesson he learned was to heed the warning lights of constant demands for capital. Investors want to see a path to profit, but there are other things to consider, such as how much debt a business holds in relation to its other factors.
That makes the weighted average cost of capital (WACC) formula one of the most useful ways to measure how valuable a business really is.
What is weighted average cost of capital (WACC)?
The WACC is the rate at which a company’s future cash flow needs to be discounted to arrive at a present value for the business. It reflects the perceived riskiness of the cash flows.
The weighted average is an important metric for calculating profitability and how much companies spend on their business operations. Additionally, the WACC uses a formula to determine the rate between market values and costs of equities and debts.
Why is knowing the WACC important?
“It can seem a bit daunting at first, but what the WACC metric does is help quantify a company’s costs based on its capital structure,” says Alina Dragan, Head of Commercial Finance for Hoxby. “It’s a good way to judge riskiness, because the WACC is the percentage of money, per pound, a business spends on the assets it uses to remain solvent. It’s thinking about the business’s future cash flows and how they will be discounted to arrive at a current value for the company."
However, it’s not just investors who can benefit from using the WACC. Businesses themselves often run the formula in a spreadsheet or accounting software ahead of making decisions, says Dragan.
“The weighted average tells us how much interest a company owes for every pound sterling it finances,” Dragan says. “So, a firm looking at expansion, acquisition or mergers would want to run it. I’ve seen it used to measure tech companies, because in that sector borrowing can be substantial as growth is often fast and aggressive. What the person measuring the WACC is looking for is how much of a return an investor would get on their investment.”
Simply put, the higher the WACC, the greater the risk because it represents a higher expenditure on capital that investors are putting into the company.
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How to calculate WACC
WACC formula
The WACC can be calculated by applying the formula:
WACC = [(E/V) x Re] + [(D/V) x Rd x (1 - Tc)]
E = Equity market value
The market value of all the shares of a company combined (also known as market capitalisation).
Re = Equity cost
The required rate of return that a company must maintain in order to keep its investors.
D = Debt market value
The amount investors would be willing to pay to buy that debt.
V = The sum of the equity and debt market values
The combined total amount of equity and debt that a company holds.
Rd = Debt cost
The cost of debt is the interest expense paid on a loan or bond.
Tc = The current tax rate for corporations
The tax rate a business must pay to the government.
How to use the WACC formula
First, split the equity and debt. Many businesses operate with borrowed money, and the two main sources are equity and debt. Equity involves selling stocks to shareholders and other external investors, while debt involves loans or selling bonds.
The market value of the equity (E) is divided by the total capital (V) to reveal the percentage of capital made up of equity. Multiply that number by the cost of equity (Re) to get the weighted cost of a company’s equity for every pound it earns.
Market value of debt (D) is divided by total capital (V) to show the percentage of business capital made up of debt. Multiply the percentage by the cost of debt (Rd) to show the weighted cost of debt for every pound the business makes.
The cost of debt is the interest rate paid on debt (Rd) multiplied by the tax benefit (1 - Tc). This is a deduction based on businesses reducing tax liability via debt interest.
Add the two numbers together to discover the WACC.
Example of WACC calculation
In application, if a business is considering an acquisition and has the following information about a business, below is a WACC calculation it could make.
The target company has £15,000 of equity and £5,000 of debt. The cost of the company’s equity is 13.5%, while the cost of the company’s debt is 8%. The corporate tax rate is 20%.
Debt market value (D) = £5,000
Equity market value (E) = £15,000
Debt cost (Rd) = 8%
Equity cost (Re) = 13.5%
Corporate tax rate (Tc) = 20%
In this example, the WACC would be calculated as follows:
WACC = (E / V) × Re + (D / V) × Rd × (1 − Tc)
WACC = [(15000 / 15000 + 5000) × 0.135] + [(5000 / 15000 + 5000) × 0.08 × (1 − 0.2)]
WACC = 0.10125 + 0.016 = 0.11725 or 11.725%, meaning the WACC for the target firm is 11.725%.
What factors affect WACC?
“There are a couple of caveats to consider when we apply the WACC formula,” says Dragan. “There are assumptions that matters will be somewhat stable, as it relies on the capital structure of the business not undergoing any drastic change like having to take out a huge loan. That’s the kind of change which does happen, frequently.”
It also counts on the risk profile remaining relatively established, but when the economic environment is fraught, things can change, and quickly.
Dragan says: “It’s not beyond the realms that inaccurate guesswork means good investments are ignored, while other investments seem more appealing than they are.”
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