What is the Weighted Average Cost of Capital (WACC)?
Weighted average cost of capital is the average rate of return a company is expected to pay to all of its shareholders who; which includes, debt holders, equity shareholders and preferred equity shareholders; who have a different rate of return each because of the pecking order and hence the difference in weighted average cost of capital.
WACC is the weighted average of the cost of a company’s debt and the cost of its equity. Weighted Average Cost of Capital analysis assumes that capital markets (both debt and equity) in any given industry require returns commensurate with the perceived riskiness of their investments. But does WACC help the investors decide whether to invest in a company or not?
To understand the Weighted Average Cost of Capital, let’s take a simple example.
Suppose you want to start a small business! You go to the bank and ask that you need a loan to start off. A bank looks at your business plan and tells you that it will lend you the loan, but there is one thing that you need to do. Bank says that you need to pay 10% interest over and above the principal amount that you are borrowing. You agree, and the bank lends you the loan.
Now to avail the loan, you agreed to pay a fee (interest expense). This “fee” is the “cost of capital” in simple terms.
As business needs a lot of money to invest in the expansion of its products and processes, they need to source money. They source money from their shareholders in the form of Initial Public OfferingsInitial Public OfferingsInitial Public Offering (IPO) is when the shares of the private companies are listed for the first time in the stock exchange for public trading and investment. This allows a private company to raise the capital for different purposes. (IPO), and they also take a loan from banks or institutions. For having this large sum of money, companies need to pay the cost. We call this as the cost of capital. If a firm has more than one source where they take funds from, we need to take a weighted average of the cost of capital.
How relevant is WACC?
It’s an internal calculation of a firm’s cost of capital. And when investors evaluate investing in a business or a firm, they calculate the weighted average cost of capital (WACC). For example, investor A wants to invest in Company X. Now A sees that the Weighted Average Cost of Capital of Company X is 10% and the return on capital at the end of the period is 9%, The return on capital of 9% is lower than the WACC of 10%, A decides against investing in this company X as the value he will get after investing into the company is less than the weighted average cost of capital.
Many investors don’t calculate WACC because it’s a little complex than the other financial ratiosFinancial RatiosFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on.. But if you are one of those who would like to know how weighted average cost of capital (WACC) works, here’s the formula for you
WACC Formula = (E/V * Ke) + (D/V) * Kd * (1 – Tax rate)
- E = Market Value of Equity
- V = Total market value of equity & debt
- Ke = Cost of Equity
- D = Market Value of Debt
- Kd = Cost of Debt
- Tax Rate = Corporate Tax Rate
The equation may look complex, but as we learn each term, it will begin to make sense. Let’s begin.
Market Value of Equity
Let’s start with the E, the market value of equity. How should we calculate it? Here’s how –
- Let’s say Company A has outstanding shares of 10,000, and the market price of each of the shares at this moment is the US $10 per share. So, the market value of equity would be = (outstanding shares of the Company A * market price of each share at this moment) = (10,000 * US $10) = US $100,000.
- The market value of equity can also be termed as market capitalization. By using the market value of equity or market capitalization, investors can know where to invest their money and where they shouldn’t.
Market Value of Debt
Now, let’s understand the meaning of the market of value of debt, D. How to calculate it?
- It’s difficult to calculate the market value of debt because very few firms have their debt in the form of outstanding bonds in the market.
- If the bonds are listed, we can directly take the listed price as the Market value of Debt.
- Now, let’s go back to the Weighted Average Cost of Capital and look at V, the total market value of equity and debt. It is self-explanatory. We just need to add the market value of equity and estimated market value of debt, and that’s it.
Cost of Equity
- Cost of EquityCost Of EquityCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns. (Ke) is calculated using the CAPM Model. Here’s the formula for your reference.
- Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of Return – Risk-free Rate of Return)
- Here, Beta = Measure of risk calculated as a regression of the company’s stock price.
- CAPM model was discussed extensively in another article – CAPM BetaCAPM BetaCAPM Beta is an essential theoretical measure of how a single stock moves with respect to the market. In this method, we determine the cost of equity by summing up the beta and risk premium product with the risk-free rate.. Please do have a look at it if you need more information.
Cost of Debt
- We can Calculate the cost of debt using the following formula – Cost of Debt = (Risk-Free Rate + Credit Spread) * (1 – Tax Rate)
- As the cost of debt (Kd) is affected by the rate of tax, we consider the After-Tax Cost of Debt.
- Here, credit spread depends on the credit rating. Better credit rating will decrease the credit spreadCredit SpreadCredit Spread is the yield gap between similar bonds but with different credit quality. If a 5-year Treasury bond yields 5% and a 5-year Corporate Bond yields 6.5 percent, the gap over Treasury is 150 basis points (1.5 percent ). and vice versa.
- Alternatively, you can also take a simplified approach to calculating the Cost of Debt. You can find take the cost of Debt as Interest Expense / Total Debt.
- Tax Rate is the Corporate Tax Rate, which is dependent on the Government. Also, note that if preferred stock is given, we also need to take into account the cost of preferred stock.
- If preferred stock is included, here would be the revised WACC formula – WACC = E/V * Ke + D/V * Kd * (1 – Tax Rate) + P/V * Kp. Here, V = E + D + P and Kp = Cost of Preferred Stocks
The interpretation really depends on the return of the company at the end of the period. If the return of the company is far more than the Weighted Average Cost of Capital, then the company is doing pretty well. But if there is a slight profit or no profit, then the investors need to think twice before investing in the company.
Here is another thing you need to consider as an investor. If you want to calculate the Weighted Average Cost of Capital, there are two ways you can use. First is the book value, and the second is the market value approach.
As you can see that if you consider the calculation using market value, it’s far more complex than any other ratio calculation; you can skip and decide to find the weighted average costAverage CostAverage cost refers to the per-unit cost of production, calculated by dividing the total production cost by the total number of units produced. In other words, it measures the amount of money that the business has to spend to produce each unit of output. of capital (WACC) on the book value given by the company in their Income statement and in the Balance Sheet. But book value calculation is not as accurate as the market value calculation. And in most of the cases, market value is considered for the Weighted Average Cost of Capital (WACC) calculation for the company.
WACC Calculation – Very Basic Numerical Example
As there are so many complexities in WACC (weighted average cost of capital) calculation, we will take one example each for calculating all the portions of the weighted average cost of capital (WACC), and then we will take one final example to ascertain the Weighted Average Cost of Capital in a simple manner.
Let’s get started.
Step # 1 – Calculating Market Value of Equity / Market Capitalization
Here are the details of Company A and Company B –
|In US $||Company A||Company B|
|Market Price of Shares||100||90|
In this case, we have been given both the numbers of outstanding shares and the market price of shares. Let’s calculate the market capitalization of the Company A and Company B.
|In US $||Company A||Company B|
|Outstanding Shares (A)||30000||50000|
|Market Price of Shares (B)||100||90|
|Market Capitalization (A*B)||3,000,000||4,500,000|
Now we have the market value of equity or market capitalization of Company A and Company B.
Step # 2 – Finding Market Value of Debt)
Let’s say we have a company for which we know the total debt. Total Debt (T) = US $100 million. In order to find the market value of Debt, we need to check if this debt is listed.
If yes, then we can directly pick the latest traded price. If the trading value was $84.83 for a face value of $100, then the market value of debt will be $84.83 million.
Step # 3 Calculate Cost of Equity
- Risk Free Rate = 4%
- Risk Premium = 6%
- Beta of the stock is 1.5
Cost of Equity = Rf + (Rm-Rf) x Beta
Cost of Equity = 4% + 6% x 1.5 = 13%
Step # 4 – Calculate the Cost of Debt
Let’s say we have been given the following information –
- Risk free rate = 4%.
- Credit Spread = 2%.
- Tax Rate = 35%.
Let’s calculate the cost of debt.
Cost of Debt = (Risk Free Rate + Credit Spread) * (1 – Tax Rate)
Or, Kd = (0.04 + 0.02) * (1 – 0.35) = 0.039 = 3.9%.
Step # 5 – WACC (weighted average cost of capital) Calculation
So after calculating everything, let’s take another example to WACC calculation (weighted average cost of capital).
|In US $||Company A||Company B|
|Market Value of Equity (E)||300000||500000|
|Market Value of Debt (D)||200000||100000|
|Cost of Equity (Re)||4%||5%|
|Cost of Debt (Rd)||6%||7%|
|Tax Rate (Tax)||35%||35%|
We need to calculate WACC (Weighted Average Cost of Capital) for both of these companies.
Let’s look at the WACC formula first –
WACC Formula = E/V * Ke + D/V * Kd * (1 – Tax)
Now, we will put the information for Company A,
weighted average cost of capital formula of Company A = 3/5 * 0.04 + 2/5 * 0.06 * 0.65 = 0.0396 = 3.96%.
weighted average cost of capital formula of Company B = 5/6 * 0.05 + 1/6 * 0.07 * 0.65 = 0.049 = 4.9%.
Now we can say that Company A has a lesser cost of capital (WACC) than Company B. Depending on the return both of these companies make at the end of the period, we would be able to understand whether, as investors, we should invest into these companies or not.
WACC Calculation – Starbucks Example
Assuming that you are comfortable with the basic WACC examples, let us take a practical example to calculate the WACC of Starbucks. Please note that Starbucks has no preferred shares and hence, the WACC formula to be used is as follows –
WACC Formula = E/V * Ke + D/V * Kd * (1 – Tax Rate)
Step 1 – Find the Market Value of Equity
Market Value of Equity = Number of shares outstanding x current price.
The market value of equity is also market capitalization. Let us look at the total number of shares of Starbucks –
source: Starbucks SEC Filings
- As we can see from above, the total number of outstanding shares is 1455.4 million
- Current Price of Starbucks (as of the close of December 13, 2016) = 59.31
- Market Value of Equity = 1455.4 x 59.31 = $86,319.8 million
Step 2 – Find the Market Value of Debt
Let us look at the balance sheet of Starbucks below. As of FY2016, the book value of Debt is current
As of FY2016, book value of Debt is the current portion of long-term debtThe Current Portion Of Long-term DebtCurrent Portion of Long-Term Debt (CPLTD) is payable within the next year from the date of the balance sheet, and are separated from the long-term debt as they are to be paid within next year using the company’s cash flows or by utilizing its current assets. ($400) + Long Term Debt ($3202.2) = $3602.2 million.
source: Starbucks SEC Filings
However, when we further read about Starbucks debt, we are additionally provided with the following information –
source: Starbucks SEC Filings
As we note from above, Starbucks provides the fair value of the Debt ($3814 million) as well as the book value of debtBook Value Of DebtThe book value of debt is the total amount the company owes, which is recorded in the company's books. It is used in liquidity ratios compared to the company's total assets to check if the organization has enough support to overcome its debt.. In this case, it is prudent to take the fair value of debt as a proxy to the market value of debt.
Step 3 – Find the Cost of Equity
As we saw earlier, we use the CAPM model to find the cost of equityFind The Cost Of EquityCost of Equity (Ke) is what shareholders expect for investing their equity into the firm. Cost of equity = Risk free rate of return + Beta * (market rate of return - risk free rate of return). .
Ke = Rf + (Rm – Rf) x Beta
Here, I have considered a 10 year Treasury Rate as the Risk-free rate. Please note that some analysts also take a 5-year treasury rate as the risk-free rate. Please check with your research analyst before taking a call on this.
source – bankrate.com
Equity Risk Premium (Rm – Rf)
Each country has a different Equity Risk Premium. Equity Risk Premium primarily denotes the premium expected by the Equity Investor.
For the United States, Equity Risk Premium is 6.25%.
source – stern.nyu.edu
Let us now look at Starbucks Beta Trends over the past few years. The beta of Starbucks has decreased over the past five years. This means that Starbucks stocks are less volatile as compared to the stock market.
We note that the Beta of Starbucks is at 0.805x
With this, we have all the necessary information to calculate the cost of equity.
Cost of Equity = Ke = Rf + (Rm – Rf) x Beta
Ke = 2.47% + 6.25% x 0.805
Cost of Equity = 7.50%
Step 4 – Find the Cost of Debt
Let us revisit the table that we used for the fair value of Debt. We are additionally provided with its stated interest rate.
Using the interest rate and fair value, we can find the weighted average interest rate of the total fair value of Debt ($3,814 million)
Effective Interest RateEffective Interest RateEffective Interest Rate, also called Annual Equivalent Rate, is the actual rate of interest that a person pays or earns on a financial instrument by considering the compounding interest over a given period. = $103.631/$3,814 = 2.72%
Step 5 – Find the Tax Rate
We can easily find the effective tax rateEffective Tax RateEffective tax rate determines the average taxation rate for a corporation or an individual. For both, there is a similar formula only with variation in considering variables. The effective tax rate formula for corporation = Total tax expense / EBT from the Income Statement of Starbucks.
Please see below the snapshot of its income statement.
For FY2016, Effective tax rate = $1,379.7 / $4,198.6 = 32.9%
Step 6 – Calculate the weighted average cost of capital (WACC) of Starbucks
We have collected all the information that is needed to calculate the Weighted Average Cost of Capital.
- Market Value of Equity = $86,319.8 million
- Market Value of Debt (Fair Value of Debt) = $3814 million
- Cost of Equity = 7.50%
- Cost of Debt = 2.72%
- Tax rate = 32.9%
WACC Formula = E/V * Ke + D/V * Kd * (1 – Tax Rate)
Weighted Average Cost of Capital formula = (86,319.8/90133.8) x 7.50% + (3814/90133.8) x 2.72% x (1-0.329)
Weighted Average Cost of Capital = 7.26%
- It assumes that there would be no change in the capital structure, which isn’t possible for all over the years, and if there is any need to source more funds.
- It also assumes that there would be no change in the risk profile. As a result of faulty assumption, there is a chance of accepting bad projects and rejecting good projects.
WACC is widely used in Discounted Cash Flow Valuation. As an analyst, we do try to perform sensitivity analysis in ExcelSensitivity Analysis In ExcelSensitivity analysis in excel helps us study the uncertainty in the output of the model with the changes in the input variables. It primarily does stress testing of our modeled assumptions and leads to value-added insights. In the context of DCF valuation, Sensitivity Analysis in excel is especially useful in finance for modeling share price or valuation sensitivity to assumptions like growth rates or cost of capital. to understand the fair value impact along with changes in WACC and growth rate.
Below is the Sensitivity Analysis of Alibaba IPO Valuation with two variables weighted average cost of capital (WACC) and growth rate.
Some of the observations that can be made about WACC –
- Fair valuation of Stock is inversely proportional to the Weighted average cost of capital.
- As the Weighted Average Cost of Capital increases, the fair valuation dramatically decreases.
- At the growth rate of 1% and the Weighted Average Cost of Capital of 7%, Alibaba Fair valuation was at $214 billion. However, when we change the WACC to 11%, Alibaba’s fair valuation drops by almost 45% to $123 billion.
- This implies that fair valuation is extremely sensitive to the weighted average cost of capital (WACC), and one should take extra precautions to correctly calculate WACC.
In the final analysis
WACC is very useful if we can deal with the above limitations. It is exhaustively used to find the DCF valuation of the company. However, WACC is a bit complex and needs a financial understanding to calculate the Weighted Average Cost of Capital accurately. Only depending on WACC to decide whether to invest in a company or not is a faulty idea. Investors should also check out other valuation ratios to make the final decision.
WACC Formula Video
This article has been a complete guide to WACC, formula, and its interpretation, along with the weighted average cost of capital examples. Here we also calculated the WACC of Starbucks and discussed its limitations and sensitivity analysis. You may also have at these articles below to learn more about valuations –