Welcome to our third and final article in the Mastering Your Working Capital
series! In this installment, we’ll dive into the Weighted Average Cost
of Capital, or WACC.
WACC is a powerful metric for evaluating investments, giving insights
into whether new projects will meet the minimum return required by both
equity and debt stakeholders. This metric reflects the full scope of a
company’s capital structure by considering loans, shareholder equity,
required returns, and corporate tax deductions. While best known for
investment analysis, WACC is versatile—it can also inform decisions in
areas like expansion, R&D, and long-term funding strategies.
A firm’s weighted average cost of capital has important applications other than the discount rate in capital project evaluations. For instance, it is a key ingredient to measure a firm’s true economic profit, or what I like to call EVA, standing for economic value added. […] Starting in the early 1990s, firms around the world—ranging from Coca-Cola, to Briggs & Stratton, Herman Miller, and Eli Lilly in America, Siemens in Germany, Tata Consulting and the Godrej Group out of India, Brahma Beer in Brazil, and many, many more—began to turn to EVA as a new and better way to measure performance and set goals, make decisions and determine bonuses, and to communicate with investors and to teach business and finance basics to managers and employees. Properly tailored and implemented, EVA is a natural way to bring the cost of capital to life and to turn everyone in a company into a capital conscientious, owner- entrepreneur.
— Bennet Stewart on Economic Value Added.
Inside the WACC Formula: Key Components Explained
The weighted average cost of capital (WACC) represents the minimum
return rate a company needs to achieve on its invested capital to meet
the expectations of its investors and cover its overall financing costs.
WACC serves as a benchmark, guiding decision-makers in assessing the
profitability of both current activities and potential future investments.
However, it’s crucial to remember that WACC isn’t a ‘one-size-fits-all’
metric; each use case requires a distinct calculation based on
specific circumstances, such as industry factors, capital structure,
and project-specific risks. Let’s start by examining the individual
components of the WACC formula.
With:
- E⁄V = the capital structure weight The proportion of financing type used by a company, commonly split in equity and debt. of equity.
- D⁄V = the capital structure weight of debt.
- V = market value
- RE = Cost of equity
- RD = Cost of debt
- TC = Corporate tax rate
Rules:
- Use the market value, not the accounting value. Market values provide a more accurate snapshot of the current costs of capital than historical, book-based accounting values.
- Ensure each component represents funds currently used in operations or earmarked for future investments, reflecting the actual sources of capital in the company’s financing structure.
-
Always calculate the debt factor
after-tax
Just like mortgage interest, corporate loan interest is tax
deductable.
For example, if a loan’s interest rate is 8%, the after-tax cost is calculated as 8% * (1 – TC), where TC is the corporate tax rate.
Example Calculation:
Interest rate = 8%
Corporate Tax Rate is 25%
E.g. 8% * (1 – 25%) = 6%. .
A simple example: if the WACC for an investment is, say 6%. Then that
serves as the required return rate to maintain the company’s value
relative to its capital costs. If we plan to invest €1,000, then the
cost of capital will be €60, calculated as follows:
1,000 * (1 + 0.06) = 1,060.
Note: In this article, we’ll simplify calculations to focus on when
and how to use WACC. In practice, calculating WACC is more complex,
often requiring financial experts who analyze various funding
sources and their associated costs. We’ll illustrate these
principles with a fictional, publicly traded company, AB Bieren N.V.
Know the Influences Impacting WACC
AB Bieren N.V. plans to open a new production line in Belgium to expand
its capacity, with an estimated investment of
5 M.
Understanding the composition of its capital structure allows us to
calculate a tailored WACC, factoring in both equity and debt costs.
For this project, AB Bieren N.V. plans to fund
50%
(2.5 M)
through issuing new stock and the remaining
50%
(2.5 M)
via a bank loan. New shareholders are promised a
15%
return, reflecting the higher risk typically associated with equity.
On the debt side, the bank, which requires lower returns on secured
loans, will charge a
4.5%
interest rate. The current Belgian corporate tax rate is 25%, which will
affect the after-tax cost of debt in our WACC calculation.
With a WACC of
0,
the minimum return from the new production line must be
0.
AB Bieren now needs to evaluate
whether they can achieve this minimum return—and ideally exceed it
to generate profit. Enter the Net Present Value (NPV).
NPV will help AB Bieren determine if the project’s returns justify
the investment, using WACC as the discount rate. The company anticipates
a 10-year service life for the production line, with an annual net
cash inflow of
2,000,000 and costs of
1,250,000, resulting in an annual
Net Cash Flow of
750,000.
The NPV formula is as follows:
According to theory, AB Bieren should proceed with the investment if the NPV is positive or zero, as this indicates that the return meets or exceeds the WACC. However, a negative NPV suggests the investment may not achieve the required returns and could be reconsidered.
Find a more detailed NPV formula here.
Leveraging debt
Despite a negative NPV, AB Bieren is committed to launching the new
production line, confident that the market demand justifies the
investment. By revisiting their financing options, AB Bieren adjusts
the capital structure to a 40-60 split: 40% from equity (investors)
and 60% from debt. Try it yourself and notice how this change
impacts the NPV.
Additionally, just on 17 October 2024, the European Central Bank (ECB)
announced plans to
lower the interest rates,
giving AB Bieren leverage to renegotiate its loan rate down to 4%.
With these adjustments, the NPV turns positive, reaching €78,277,
allowing AB Bieren to green-light the project. This approach is
known as “leveraging debt”—a strategy used to enhance returns by
increasing debt financing when conditions are favorable. However,
it’s essential to manage debt levels carefully, as too much leverage
introduces higher financial risk.
Notice how these changes also impact the WACC. This sensitivity to
factors like capital structure and interest rates underscores the
importance of WACC and its components. Getting WACC right is crucial
for a company to make sound investment decisions. Yet, one final
insight remains unseen in the WACC formula: the cost of capital
hinges more on the use of funds than their source. For instance,
capital allocated to high-growth projects may justify a higher WACC,
while low-risk investments may require a lower threshold. This focus
on purpose over origin highlights that strategic, effective use of
capital is the true driver of sustainable returns and value creation.
*CFOrent-tip *: “A good practice is to make simulations of the WACC, where you incorporate various macro-economic factors that might influence the WACC. This way, we can create a better risk-profile for the investment.” Says Anthony, CFOrent associate. “However, the WACC cannot be the only metric to consider. In the end, a clear vision statement determines what investments really matter for a company. The metrics are merely tools to fine-tune the investment and to make an educated decission.”
Balancing Shareholder Equity and Debt in WACC
In calculating the Weighted Average Cost of Capital (WACC), a
company’s capital structure—its mix of shareholder equity and
debt—plays a critical role. Let’s explore why companies use a
combination of these financing sources, and how each affects the
cost of capital.
Shareholder equity represents the ownership stake in a company.
When a company raises capital by issuing shares, it gives investors
a claim on future profits. In return, shareholders expect a certain
rate of return, or cost of equity, which reflects the level of risk
they’re taking. The cost of equity tends to be higher than the cost
of debt, as shareholders assume greater risk: unlike lenders, they
are paid only after all debts are settled and receive returns based
on performance.
While equity doesn’t require fixed repayments like debt, it carries
an implicit cost—the returns shareholders expect for their
investment. This expectation is part of the WACC formula, and it
reflects the “price” a company pays to retain investor support and
avoid diluting ownership.
Why Use Debt? The Power of Leverage
Debt, on the other hand, offers an alternative financing path. Unlike equity, debt requires regular interest payments but provides several advantages:
- Lower Cost: Debt generally has a lower cost than equity because lenders assume less risk. They have a contractual right to repayment, often backed by collateral, and are typically first in line during any liquidation process.
- Tax Deductibility: Interest payments on debt are tax-deductible, reducing the company’s overall tax burden. This tax advantage lowers the effective cost of debt in the WACC formula, making it an attractive option for many companies.
- Controlled Ownership: Unlike issuing shares, debt does not dilute existing ownership, allowing current shareholders to maintain control over the company.
The Balance Between Equity and Debt
Finding the right balance between shareholder equity and debt is key to managing WACC effectively. While debt can lower WACC due to its lower cost and tax benefits, excessive debt can increase financial risk, potentially affecting credit ratings, operational flexibility, and shareholder confidence. On the other hand, too much reliance on equity may increase WACC, as equity holders expect a higher return. In the WACC calculation, the cost of equity and cost of debt are weighted according to their proportion in the company’s capital structure. By optimizing this balance, companies can achieve a lower WACC, making it easier to pursue growth opportunities with more favorable returns.
Conclusion
In understanding the Weighted Average Cost of Capital (WACC), we’ve
seen that it is far more than a simple metric. WACC serves as a
guiding compass for companies like AB Bieren N.V., helping them
evaluate whether an investment will meet the necessary returns to
satisfy both debt obligations and equity expectations. By breaking
down WACC’s components and experimenting with factors such as
capital structure and interest rates, companies can make informed
choices, optimizing their financing approach to align with strategic
goals.
But as we uncovered, calculating WACC isn’t merely about numbers.
It’s about aligning the cost of capital with the intended purpose of
the investment. Ultimately, WACC encourages businesses to use capital
wisely and strategically, driving growth in ways that create
sustainable value. With this tool, companies can approach each
investment opportunity not just with financial prudence but with an
eye toward the future—a future where every investment serves a
purpose beyond profit alone.
