Businesses and organizations use a formula known as Weighted Average Cost of Capital (WACC) to measure the cost of capital across different categories and attributing a proportional weight to each one. Different sources of capital are assessed and included in the calculation including common stock, preferred stock, bonds, and long-term debt.

The figures gained from using WACC represent the minimum return a company has to earn on an existing asset base to satisfy stakeholders like creditors, owners, or investors. It is often used to estimate a company’s cost of funding and to estimate things like potential returns or risk-free rates when evaluating potential business investments.

Equity without income is unnatural. 

– Hendrith Vanlon Smith Jr

Variables that affect WACC

There are a number of factors that will affect a company’s weighted average cost of capital (WACC). Each one will need to be taken into account when making a calculation.

WACC calculations can be combined with other financial assessment tools like discounted cash flow or capital asset pricing models to provide a clearer and more accurate assessment and project company performance.

Business structure

The combination of debt and equity that a company uses to finance its business operations has a direct impact on its WACC. As the proportion of debt increases compared to the business, the WACC decreases. This is because interest on debt is tax-deductible.

Cost of equity

The cost of equity is the rate of return that is required by investors to compensate them for the risk of investing funds in a company’s stock. A higher rate of return will equate to a higher WACC.

Tax rates

WACC is affected by corporate tax rates, and the number will change based on rates as interest on debt is tax-deductible. A lower tax rate will mean a lower WACC.

Cost of debt

WACC can be affected by the interest rate a company pays for its debt. Fluctuating rates on financial instruments such as bonds will affect WACC. The higher the interest rate, the higher the WACC will be.

Economic influences

The current state of the economy and the capital markets will have a bearing on a company’s WACC. During a recession or a slow market, for example, business investors may demand a higher rate of return to compensate for losses, which will increase the company’s WACC.

Company specific factors

Depending on the size of a company, the state of its credit rating, and the industry can also affect the WACC, as these factors can influence the cost of debt and present value of equity.

How to calculate WACC

calculating WACC

The weighted average cost of capital (WACC) is the average of the costs of all the securities a company has issued, with each security’s cost weighted by its proportion of the capital structure.

It is calculated using the following formula:

WACC Formula = (E/V * Re) + (D/V) * Kd * (1 – Tax rate)

E = Market Value of Equity

V = Total market value of equity & debt

Re = Cost of Equity

D = Market Value of Debt

Kd = Cost of Debt

Tax Rate = Corporate Tax Rate

To achieve an accurate number the market value of equity, debt, and total capital should be used in the calculation, not book value.

WACC calculation example

Finding the WACC using the formula can be done using the information for Company A and Company B below.

WACC calculation example

Source: https://www.wallstreetmojo.com/weighted-average-cost-capital-wacc/#h-wacc-formula

Finding the WACC for both of these companies using the WACC Formula

E/V * Ke + D/V * Kd * (1 – Tax) will give us an accurate calculation for both organizations.

The weighted average cost of capital formula of Company A 5 =

3.96% WACC

Using Company B’s details =

4.9% WACC

The formula for calculating WACC can be quite complex, but for companies and organizations who want to use it as a tool, the process has been made much easier with the introduction of digital financial software and accounting packages.

Assessing capital to start a business can be a daunting process 

-Gavin Newsom

How do you solve WACC problems?

Weighted average cost of capital (WACC) is a commonly used metric for evaluating a company’s cost of capital, but it is not foolproof, and the system does come with some limitations that can lead to problems.

Assumptions

One of the main issues with WACC is that it is based upon assumptions that may not always hold true. Therefore, it is important to consider the potential impact of any deviations from these assumptions on the WACC calculation. One possible solution is to use different methods for estimating the cost of equity such as the Dividend Discount model, or Comparable Company Analysis.

WACC also assumes that a company’s capital structure is static and does not change. But in reality, many companies may change their capital structure through activities such as issuing new debt or equity, or repurchasing shares.

This can lead to discrepancies between the WACC and the actual cost of capital. Regularly recalculating the WACC to reflect changes in the capital structure will help companies to avoid incorrect results.

Tax Rates

Other issues can arise when using WACC calculation around the corporate tax rate, the use of the formula assumes that the business is profitable, but if a company is not profitable, the WACC will be different from the actual cost of capital. Financial experts should be able to adjust the WACC calculation to account for this.

Market conditions

Calculating WACC at a given point in time may not be relevant at a later date. WACC is affected by economic influences and markets, which can change rapidly and WACC should be recalculated at regular intervals to capture and reflect changing conditions.

Where is the Cost of Equity on financial statements?

The cost of Equity can be an important number used for many different financial calculations. However, the cost of equity is not a line item that is reported anywhere on a company’s financial statements. It is an estimate, or a calculation based on the company’s financial information.

This information can typically be retrieved from financial software used by organizations and companies to report and track accounts. Financial accounting software includes packages like, Oracle Netsuite and Intuit Quickbooks which are used by organizations of all sizes.

Cost of equity is usually estimated using a model such as the Capital Asset Pricing Model (CAPM), which takes into account the company’s risk-free rate, the market risk premium, and the company’s beta – a measure of a stock’s volatility in relation to the overall market.

The cost of equity is not a fixed number, it’s an estimate that is sensitive to many factors such as stock market performance, and other company specific factors, so it should be revisited and recalculated periodically.

Limitations and tips for interpreting WACC

Interpreting WACC at a table with all information and employees present

The weighted average cost of capital (WACC) is a metric that is used frequently for evaluating company information, but it does have some limitations and care should be taken when interpreting the results.

Here are a few tips to keep in mind when interpreting figures gained by using the WACC formula.

Account for deviations

WACC makes assumptions and uses numbers based on market values rather than book values, and Capital Asset Pricing Model (CAPM) to estimate the cost of equity. These figures may not always be accurate, so it’s important to consider the potential impact of any deviations when calculating WACC and updated figures should be transferred to accounting software used.

Fixed capital structure

A company may change its capital structure over time with new debt or share issues. Discrepancies can arise between the WACC and the actual cost of capital.

as WACC assumes that capital structure is fixed. The actual cost of capital may need to be assessed very carefully to avoid making any mistakes.

Company comparison

Companies in different industries will have different capital structures, costs of debt, and equity, which can affect their WACC. When comparing the WACCs of different companies, it is important to understand the specific financial profile of each company.

Intent

WACC is primarily a performance evaluation metric used for evaluating things like potential investments. It should not be used as the basis for decision-making, other information and factors will need to be incorporated to gain a true picture of a company’s overall financial position.

The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. 

-Warren Buffet

Conclusion

While WACC is certainly a versatile method to gain insights into an organization’s financial position it is a guide rather than a definitive tool. Using WACC to assess the average cost of capital does have some restrictions and limitations.

For the best results, figures that are gained from using the WACC formula should always be cross-referenced with other financial metrics. Allowing company leaders, financial stakeholders, and organizations to arrive at evaluations that support the most informed and productive business decisions.