Weighted average cost of capital
The weighted average cost of capital (WACC) for a firm is the weighted average of the cost of debt and cost of equity.
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Expanded Definition
A firm uses capital in order to grow by buying assets, inventory, and research & development. Just like anything else, the capital comes with a cost, whether explicit (interest paid on debt) or implicit (the return expected by equity holders).
The company's capital comes from two sources: debt and equity. The cost of capital is the cost of the debt plus the cost of the equity, weighted by how much of each is in total capital.
Calculation
Find the amount of debt (long term and short term) and the amount of shareholders' equity from the balance sheet. Determine the relative proportions of each. For instance, if debt is $532 million and equity is $1,084 million, then the total capital is $1,616 million with 32.92% of it from debt and 67.08% from equity.
Then, determine the cost of debt. This can be as complex as figuring the interest rates on every single bond or bank loan or line of credit and weighting those, or find the interest payment and divide by the average amount of debt over the period (beginning of period balance plus end of period balance, divided by two).
Then, determine the cost of equity. This is more difficult, because there isn't an explicit payment the company makes to equity holders. Several possibilities exist.
- Use a flat rate, such as your own required rate of return.
- Take a page from Warren Buffett and use the 5-year or 10-year treasury rate plus four to seven points.
- Use the capital asset pricing model to calculate the cost of equity.
Once you have all items, multiply the cost of debt by the proportion of debt, the cost of equity by the proportion of equity, and add the results together. Note, though, because interest on debt is paid before taxes are paid, that has to be accounted for.
Expanding on the example from above, suppose the cost of debt is 4.3%, the tax rate is 35%, and the cost of equity is 9.7%, then the weighted average cost of capital would be:
<math>WACC = (1 - 35%) * 4.3% * 0.3292 + 9.7% * 0.6708 = 1.4% + 6.5% = 7.4%</math> {1.4% is not right: 1-.35=.65*.043*0.3292=0.9%}
The WACC is often used when completing a discounted cash flow model as the rate at which to discount the future cash flows back to the present.
Implications
In order to generate value, a company has to generate a return on capital that is more than the cost of that capital. Several points, at least. If the WACC calculation has to be jiggered to show that yes, indeed, the company is doing so, then the company is too close to the line. Take the following situation, for instance:
Metric | 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 |
ROIC | 20.4% | 16.8% | 8.8% | 4.4% | 9.4% | 6.2% | 5.3% | 4.4% |
WACC | 5.7% | 9.3% | 6.0% | 8.3% | 8.5% | 7.5% | 5.8% | 4.6% |
For 2001 and 2002, the spread is fantastic and this company could be worth investing in. For 2003, not so good, but still fair. But from 2004 on, this company was, at best, barely making its cost of capital and, more realistically, destroying value. Not worth your investment dollars. In fact, the share price for this company went nowhere during that time, despite rising revenue and earnings (and there was no dividend to pay you to wait).
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