Weighted cost of capital (WACC) is a method for calculating a company’s average cost of money where the cost of each form of financing is proportionally weighted. WACC is an abbreviation of the English Weighted Average Cost of Capital.
When calculating WACC, the company’s current financing is used as a starting point, and the cost after tax is calculated for each form of financing. The costs for each form of financing are weighed together based on how large a part of the total capital structure each form of financing constitutes. WACC is thus a weighted average of the financiers’ required return on invested capital. In other words, WACC represents the average cost a company must pay to all investors and lenders for invested money.
The cost of capital is driven by how risky the company’s operations are—the more complex the business, the higher the required return. A distinction is made between the required rate of return for equity and borrowed capital (also called debt). The necessary return on equity corresponds to the return required by investors to buy shares in the company at the time of valuation. The required rate of return on borrowed capital corresponds to the interest cost of borrowed money after tax, i.e., the effective annual interest rate on the company’s loan, less standard tax. Interest costs are calculated after tax because they are generally deductible.
Usually, the required return on equity is higher than on borrowed capital. The shareholders take a greater risk than the lenders in that repayment of borrowed money is prioritized in the event of bankruptcy. A larger share of loan financing should. Thus, all other things being equal, it reduces the weighted cost of capital. However, the required return on equity is not independent of indebtedness. With increased indebtedness, the risk level in the company also increases, which in turn leads to an increased required return on equity.
What is WACC?
WACC stands for “weighted average cost of capital.” Thus, a weighted value of money / a specified return is required to satisfy a firm and its owners. It is the interest rate on its assets that it should quickly produce.
Because investors demand a more significant return on their money when the risk is high, a high WACC frequently suggests a substantial stake in the firm. A lower WACC (return requirement) typically means lesser risk. Consider the oil sector (which is high) vs. the real estate industry (which is cheap) (low).
When is WACC Used?
For example, calculations when the cost of capital is used, such as in a DCF model or an NPV calculation. Then, you discount future cash flows with the cost of capital. A low WACC renders a higher value in a DCF model than a high WACC. With an NPV calculation, it becomes more difficult to recoup an investment with a high WACC.
Calculate WACC
The most common formula can be seen below:
Formula Explanation
- WACC = weighted cost of capital
- E = equity
- V = equity + borrowed capital
- Re = required return on equity
- D = borrowed capital
- Rd = borrowing rate
- Tc = tax rate
What is the Desired (Optimal) Capital Structure?
An optimal capital structure is a mixture of equity and borrowed capital, resulting in the lowest weighted cost of capital (WACC). The lower the WACC, the greater the present value of the company’s forecast future free cash flows. There are incentives for companies to strive for the capital structure that results in the lowest WACC, which maximizes the company’s value (and thus the shareholder value).
As previously mentioned, the required rate of return (cost) for equity is often higher than for borrowed capital. In the case of a capital structure that only consists of equity, WACC is equal to the required return on equity. An increasing share of loan financing should thus (all other things being similar) reduce the weighted cost of capital until the optimal capital structure is reached. However, the required return on equity is not independent of indebtedness. Once this point has been passed, the adverse effects of an over-leveraged capital structure are expected to exceed the cost benefits of loan financing. With increased indebtedness, the risk level in the company also increases (including the risk of insolvency). Lenders and shareholders demand higher returns at an increased risk level, leading to increased WACC.
WACC in Various Companies and Industries
WACC (average weighted cost of capital) is different for different industries and companies, and it is impossible to give a concrete or correct answer for the correct WACC.
You can use a rule of thumb that the more risk, the higher the WACC. You probably calculated correctly if you calculate WACC and end up somewhere between 8 and 18%.
Usually, the WACC is around 12-14%, so if you have a medium-sized company and do not know what value to put – you can put 14%. That said, it’s arbitrary.
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