WACC Cost of Capital | Go Beyond the Definition

WACC Analysis

The weighted average cost of capital (WACC) is the rate companies must pay to finance their assets; in other words, the minimum return a company must earn on their existing assets to satisfy creditors, owners, and other providers of capital. Click here to experiment with a Simple WACC Calculator or the more complicated Industry WACC Calculator / Template.

WikiWealth empowers users to experiment with our WACC analysis. Find the "experiment" link on any of our stock research reports. (see tutorial ).

The WACC Discount Rate Analysis (weight average cost of capital, present value factor, discount rate): The weighted average cost of capital (WACC) is the rate that a company is expected to pay to finance its assets. WACC is the minimum return that a company must earn on their existing asset base to satisfy its creditors, owners, and other providers of capital. For example, Uncle Bob borrows 15,000 dollars to buy comic books as an investment. You must account for the return you would get from the bank if you left the money in savings plus the cost of inflation. You must also account for the risk of a fire, bad comic investment choices, and a bad economy among many other risks. These are some of the risk factors accounted for in the WACC analysis.

Importance to Investors:

• If an investor invests money in a project or stock, they expect a return on that money that is above all the risk to that money. The higher the risk of a project, the greater is the expected return to compensate for those risk. A higher WACC raises the bar for your investments, but if your investments have very high returns, then you are compensated for those risks.

What is the WACC?

• WACC is the weighted average cost of capital. An expanded definition is available by clicking here.

How does Wikiwealth use the WACC?

• Wikiwealth projects the expected free cash flow of a business and discounts those cash flows using the WACC calculation.

Why is an industry WACC more accurate?

• Wikiwealth makes the assumption that an industry average WACC calculation is the optimal configuration of a company. If a company has more debt than the rest of the industry, we assume company-specific debt level will match the industry level in the future. The same assumption is made for equity, taxes, beta and many other variables that go into the WACC calculation.

Determine the cost of equity (required return of equity)?

• We use the CAPM (capital asset pricing model) to determine the cost of equity. CAPM equals the risk free rate plus beta times the market risk premium. The cost of equity is the rate a target company would have to pay for equity capital (financing) such as in an IPO.

Variables and assumptions in the CAPM?

• Risk free rate: we use a risk-free rate equal to the US Treasury 20 year benchmark. This rate is risk free, because the US government is considered the closest measure of a risk free investment.
  • If the target company is foreign, we would use the appropriate government risk free rate in their domestic market.
  • We use the 20 year rate, because an investor is expected to hold a long term investment for 20 years. Why not a 30 year risk free rate? The 30 year rate is usually lower than the 20 year rate, because of the market’s lopsided demand for longer duration securities. The most conservative number to use is the 20 year rate.

• Beta: This determines the risk of an investment as compared to the stock market in general. If the beta of an investment is 2.0, then it would move with twice the magnitude of the market. For example, if the market was down 5%, a beta of 2.0 means that your investment would drop by 10%.
  • Ideally, the beta should measure the expected future risk of the company. Most beta measures take the historical beta (or regression versus the stock market in the past) and assume the relationship would stay the same going forward.
  • Wikiwealth currently uses a beta calculated by a proprietary source, but this will change in the near future. In an effort to be more transparent, Wikiwealth will calculate the beta using historical regressions versus the stock market.

• Market Risk Premium: The market risk premium equals the equity risk premium minus the risk free rate.
  • The equity risk premium is the amount of return an investor expects from equity investments. It is calculated using historical information. The risk free rate is explained above.
  • Wikiwealth uses a market risk premium of 5%, which is the long-term conservative risk premium for the market.

Determine the cost of debt (required return of debt)?

• Wikiwealth uses the BBB corporate bond yield to determine the cost of debt. There are several assumptions underlying this measure. The cost of debt is the rate a target company would have to pay for debt capital (financing) such as in a debt offering to the public.
  • The BBB measure is the assumed average measure of the debt rating for the target company. If the debt rating is significantly different from the market, then we would use a different corporate bond yield, like AAA or CCC. We rarely diverge from the BBB average unless the entire industry was significantly different from BBB. The BBB rating equates to the risk of the target companies debt.
  • We use the 20 year bond rating, because 20 years matches the expected holding period of the investment.
  • After-tax cost: Wikiwealth uses the after-tax cost of debt, because companies get a tax shield on interest expenses.
    • The tax rate is the domestic corporate tax rate. For US companies, this rate equals 40%, which is the federal and state blended tax rate. Foreign companies use different tax rate.

Determine the percentage of equity in a company?

• The equation equals the percentage of equity divided by total capital in a company.
  • Equity equals the stock price multiplied by the shares outstanding. Shares outstanding are found on the cover of financial statements.

Determine the percentage of debt in a company?

• Wikiwealth adds long term and short term interest bearing debt plus capital leases, preferred debt and minority interest to equal total debt in a target company. These are all the debt holders in the company who have claim to the equity of the company in case of bankruptcy.
  • Why do we use interest-bearing debt? This is the return owed to debt holders of the company. In the cash flow valuation, we determine the value of the total company to both equity and debt holders combined. So part of the cash flow goes to debt holders and the rest goes to equity holders.
    • We find cash flow to both debt and equity combined, because it requires fewer assumptions and is thus a less risky valuation model.

What is the Country Risk Premium?

• This is the added premium needed by investors in order to invest in risky countries. The CPR is added to the cost of equity (required return on equity).
  • There is no risk premium for the United States or many other developed countries with fluid capital markets.

What is Alpha?

• The risk factors not incorporated into the financial data of a company, such as in the case of bankruptcy or other financial distress. Wikiwealth adds alpha to the ending value of the WACC.

Why do we round the WACC calculation?

• We at Wikiwealth are not genius, so we round the WACC to indicate that the value is very difficult to predict with accuracy. A non-rounded number creates the illusion of perfection and contributes to manipulation of the results. Hopefully, only fundamental changes will cause differences in the value of the WACC and thus the company’s value.

Weighted Average Cost of Capital (WACC). The two components of capital include the cost of debt and the cost of equity capital. The weighted average cost of capital (WACC) is the rate that a company is expected to pay to finance its assets. WACC is the minimum return that a company must earn on their existing asset base to satisfy its creditors, owners, and other providers of capital.

The Industry WACC is an average WACC measurement for companies in an industry. The Industry WACC used statistics such as debt, equity, tax rate, beta measurements to find the correct average WACC for an industry. Wikiwealth applies the industry WACC to individual companies to find a stable and optimal WACC discount rate for that particular company. All individual companies are expected to converge to the industry WACC over time.

Companies raise money from a number of sources: common equity, preferred equity, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, and so on. Different securities are expected to generate different returns. WACC is calculated taking into account the relative weights of each component of the capital structure. Calculation of WACC for a company with a complex capital structure is a laborious exercise.

WACC = wd (1-T) rd + we re

wd = debt portion of value of corporation
T = tax rate
rd = cost of debt (rate)
we = equity portion of value of corporation
re = cost of internal equity (rate)

How it works

Since we are measuring expected cost of new capital, we should use the market values of the components, rather than their book values (which can be significantly different). In addition, other, more "exotic" sources of financing, such as convertible/callable bonds, convertible preferred stock, etc., would normally be included in the formula if they exist in any significant amounts - since the cost of those financing methods is usually different from the plain vanilla bonds and equity due to their extra features.

WACC is a special way to measure the capital discount of the firms gaining and spending.

Sources of information

How do we find out the values of the components in the formula for WACC? First let us note that the "weight" of a source of financing is simply the market value of that piece divided by the sum of the values of all the pieces. For example, the weight of common equity in the above formula would be determined as follows:

Market value of common equity / (Market value of common equity + Market value of debt + Market value of preferred equity).

So, let us proceed in finding the market values of each source of financing (namely the debt, preferred stock, and common stock).

• The market value for equity for a publicly traded company is simply the price per share multiplied by the number of shares outstanding, and tends to be the easiest component to find.

• The market value of the debt is easily found if the company has publicly traded bonds. Frequently, companies also have a significant amount of bank loans, whose market value is not easily found. However, since the market value of debt tends to be pretty close to the book value (for companies that have not experienced significant changes in credit rating, at least), the book value of debt is usually used in the WACC formula.

• The market value of preferred stock is again usually easily found on the market, and determined by multiplying the cost per share by number of shares outstanding.

Now, let us take care of the costs.

• Preferred equity is equivalent to a perpetuity, where the holder is entitled to fixed payments forever. Thus the cost is determined by dividing the periodic payment by the price of the preferred stock, in percentage terms.

• The cost of common equity is usually determined using the capital asset pricing model.

• The cost of debt is the yield to maturity on the publicly traded bonds of the company. Failing availability of that, the rates of interest charged by the banks on recent loans to the company would also serve as a good cost of debt. Since a corporation normally can write off taxes on the interest it pays on the debt, however, the cost of debt is further reduced by the tax rate that the corporation is subject to. Thus, the cost of debt for a company becomes (YTM on bonds or interest on loans) × (1 − tax rate). In fact, the tax deduction is usually kept in the formula for WACC, rather than being rolled up into cost of debt, as such:

WACC = weight of preferred equity × cost of preferred equity

weight of common equity × cost of common equity
weight of debt × cost of debt × (1 − tax rate).

And now we are ready to plug all our data into the WACC formula.

See Dictionary Terms

• Value Investing
• Terminal Value
• Risk Free Rate
• Required Return of Equity
• Required Return of Debt
• Present Value of Free Cash Flow
• Present Value Factor
• Free Cash Flow
• Fair Value

See Academic Resources

• WACC Discount Rates
• WACC Discount Rate Model
• Private Equity Discount Rate
• WACC Calculator

Source: http://en.wikipedia.org/wiki/Weighted_average_cost_of_capital