Finance: WACC for the Uninitiated

WACC stands for “Weighted Average Cost of Capital”. WACC is used by investors and analysts,¬†for a variety of purposes including as a way to assess perspective investments. This post is meant to give a very basic overview of what this concept is, and why it is important.

The Cost of Capital

A company’s capital is obtained through two sources:

  1. Debt – capital obtained from lenders, such as a bank loan or bond issuance
  2. Equity – capital invested by shareholders, such as stock

Each of these sources has associated costs. The cost for debt is the interest that must be paid on that debt. The cost of equity is the return that an investor expects to receive from their investment.

These costs are demonstrated as percentages. For example:

  • A bank may charge 5% interest on a long-term loan
  • An investor may expect a 10% return on their investment

The Weighted Average

A “weighted average” is way of calculating the average of a set of numbers, wherein some numbers carry more weight than others.

A basic way to illustrate this is by using grades. Suppose John is in a Finance class that is graded by 7 assignments and 1 final test. Each assignment is worth 10% of his grade (so 70% total). The final test is worth 30% of his grade.

If John has an average assignment score of 96% and then receives an 80% on the final, what is his final grade? We can determine his final grade by using a weighted average calculation as so:

John’s grade = (0.70) * (96)+ (0.30) * (80) = 91.2

Weighted Average Cost of Capital

Now that we understand these concepts, we can put them together to understand what “Weighted Average Cost of Capital” is.

The formula for calculating WACC is as follows:

WACC = (E/V * Re) + (D/V * Rd) * (1 -Tc)

Where:

  • E = the firm’s equity
  • V = Equity + Debt
  • Re = the Cost of Equity
  • D = the firm’s Debt
  • rd = the Cost of Debt
  • Tc = the corporate tax rate (which must also be considered)

For example:

Let’s suppose that Acme, Inc. has $1000 in capital. $700 is debt at 5% interest, and $300 is equity with an expected 10% return. Let’s also say that the corporate tax rate is 2%. To calculate Acme, Inc.’s WACC, we would do the following equation:

WACC = (300/1000 * 0.10) + (700/1000 * 0.05) * (1 – 0.02)

The WACC of Acme, Inc. is 6.43%. That is, the Weighted Average Cost of the Capital that Acme, Inc. has received through it’s various financing activities is 6.43%.

Why is WACC Important?

Investors use WACC in a variety of ways to analyze the value of an investment. For example, the WACC can represent the minimum rate of return that investors should accept from a company. So that if the company is returning more than the WACC, then it may be considered a good investment. However, if it is returning less than WACC, then the investment would be considered bad.

WACC is also used in:

  • Discounted Cash Flow Analysis – a method of estimating the value of an investment based on the future cash flows that the investment is expected to produce
  • ROIC Performance Assessment – a method of assessing how effective a company is at utilizing it’s capital
  • Calculating Economic Value Added – a measure of business’s financial performance

Conclusion

I find finance to be a very interesting topic. Gaining financial literacy is very important. If nothing else, it will enable you to take greater control of your financial state – you will be able to independently determine if that house is a good investment, if you can afford that new car, or if your retirement plan is optimal.

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