Unlike personal finances, business finances are far more complicated and often require multiple funding sources. On top of what they bring in from products or services, a successful business will often balance their books through a combination of sources – including debt and equity financing. The price of their operations is reflected in the weighted average cost of capital (WACC).
If you are considering investing in a company, understanding this measurement can help you determine if its stock has room to grow or if its progress is limited by how the business is being financed.
What Is WACC?
In investing terms, WACC shows the average rate that companies pay to finance their overall operations. WACC is calculated by incorporating equity investments from the sale of stock, as well as any operational debt they incur (with respect to the firm’s enterprise value).
WACC shows how much a company must earn on their existing assets to satisfy the interests of both their investors and debtors.
Where Is WACC on the Balance Sheet?
WACC is sometimes simplified as the “cost of capital” and may be referred to “right side finances”. In ledgers, the right side of the budget sheet always lists the combined financing sources a company uses (including financing and debt). Thus, the key factors that are used to calculate WACC are on the right side of the balance sheet.
What Does WACC Tell Us?
For investors, WACC is important because it details how much money a company must make in order to provide returns for stakeholders. As its name suggests, the weighted average cost of capital can change based on several factors, including the rate of return on equity.
An increase of WACC suggests that the company’s valuation may be going down because it’s using more debt and equity financing to operate. On the opposite side, a decreased WACC shows the company is growing earnings and relying less on outside funding.
Because WACC is not directly represented in financial statements, it must be calculated from the information available on quarterly statements. The WACC formula is:
When Calculating WACC, What Capital Is Excluded?
Using WACC to calculate the cost of debt focuses on the two sources of financing: equity financing and debt financing. Accounts payable and accruals are not considered in the WACC formula. These sources of income are not supplied by creditors or investors, so they are not added to WACC.
What Is a Good WACC?
As a general rule, lower WACC levels suggests that a company is in a prime position to more cheaply finance projects, either through the sale of stocks or issuing bonds on their debt. The business is producing enough through earnings to reduce overall debt load and providing continuous returns to investors, which may encourage fundraising rounds to spur growth.
If a company has a higher WACC, it suggests the company is paying more to service their debt or the capital they are raising. As a result, the company’s valuation may decrease and the overall return to investors may be lower.
Is a High WACC Good or Bad?
Although a higher WACC creates cause for concern, it isn’t necessarily a negative mark for a company. In some situations, a company may issue corporate bonds to fuel corporate expansion or purchase new physical assets. Even when WACC is minimized, it’s plausible that this will be negated over time. A company prospectus will often offer insight into why a company is raising debt or seeing equity financing, which – alongside WACC – can help you determine if it’s a good investment.
Can WACC Be Zero?
Because WACC considers both debt and outstanding equity in a company, WACC cannot be zero. If a company holds zero debt, then its WACC will only be the measurement of its equity financing, using the capital asset pricing model. On the contrary, if a company has zero investors, then the WACC is used to calculate the cost of debt.
Can WACC Be Adjusted?
In itself, WACC cannot be adjusted. However, if a company starts taking on additional risk through expanding their product line or services, the gains and risk aspects of WACC can be adjusted. For instance, adjusting a company’s beta measurement or the cost of debt can change the model, providing analysis on how likely a project will result in positive gains.
WACC and the Discount Rate
WACC is used to determine a company’s potential based on their current financing options.
The discount rate, however, is the interest rate that investors use in calculating cash flow through the discounted cash flow valuation. An investor would use WACC to determine the potential in an investment today while they would use discounted cash flow to account for the time value of money and project future returns.
How WACC Is Used to Calculate NPV
WACC is important in the calculation of Net Present Value (NPV) because it represents the current costs of financing. NPV is used to evaluate investment proposals for the future by taking the time value of money into account, along with the discount rate.
When WACC is used to determine NPV, it ultimately provides a vision into the potential success rate of an expansion via investment. Projects with an NPV above 0 suggest that an investment project will provide a positive return, suggesting a potentially good investment.
For an example of weighted average cost of capital, let’s consider the financial position of two companies in the same quarter:
Market Price of Shares
Market Value of Debt
Cost of Equity
Cost of Debt
Using the formula above, the WACC for A Corporation is 0.96 while the WACC for B Corporation is 0.80. Based on these numbers, both companies are nearly equal to one another, but because B Corporation has a higher market capitalization, their WACC is lower (presenting a potentially better investment opportunity than A Corporation).
Where to Find WACC in Financial Statements
Companies don’t usually advertise their WACC on their financial statements. However, by understanding several factors about a company, it’s easy to determine their weighted average cost of capital.
To calculate WACC, you will need to read through a quarterly statement to find the factors used in our example of weighted average cost of capital. While current market capitalization and the tax rate is easy to find, the market value of debt requires investors to calculate the entire debt load as one single bond coupon by using the bond quote formula.
WACC vs. CAPM
While WACC is a measurement of the average a company plans on paying on their financing options (including stock and debt), the capital asset pricing model (CAPM) is a different investing measurement.
CAPM measures the potential rate of return on an investment, especially where a high amount of risk is involved. While WACC shows how much money a company needs to make to offer value for stakeholders, CAPM suggests if a stock at a given price is a good or bad purchase based on risk and rate of return.
WACC vs. IRR
WACC is much different from Internal Rate of Return (IRR) because they measure two different concepts. While WACC measures the cost of operations through financing, Internal Rate of Return measures the break-even point for a specific project or investment. IRR is useful for measuring expected rate of return and for determining whether an investment is worthwhile.
Ask An Expert About WACC
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Why Does WACC Decrease When Debt Increases?
Equity financing dilutes ownership shares of a company, which can ultimately hurt investors over time. However, debt financing’s sole cost is the interest paid and it doesn’t push risk onto investors. Therefore, it’s not unusual for WACC to decrease when debt increases (because the company is solely responsible for the weight of the financing).
Why Is WACC Less Than the Cost of Equity?
WACC considers not only the cost of equity, but the after-tax costs of debt as well. That’s because the total cost of equity and cost of debt are added together, then multiplied by earnings after the tax rate is applied to calculate a weighted average. Therefore, WACC is less than the cost of equity because the after-tax cost of debt is lower than the cost of equity.
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