The meaning of WACC and its importance in business valuation

When it comes to investing, many investors tend to focus solely on the expected returns. However, in reality, there is an important factor that should not be overlooked: the cost of capital that the company uses to operate. If you want to make well-informed investment decisions, understanding the meaning of WACC or the weighted average cost of capital is essential and worth studying further.

Understanding the WACC Meaning: What Does It Mean?

WACC, which stands for Weighted Average Cost of Capital, refers to the average cost of funds. It is a financial metric that indicates the appropriate discount rate for evaluating investment projects or a business.

In practice, WACC is used to measure the total cost that a company must consider to raise funds from various sources, whether through borrowing from financial institutions or raising equity from shareholders. A lower WACC indicates that the company can source capital efficiently, which is a positive sign for financial sustainability.

Main Components of the Weighted Average Cost of Capital

WACC consists of two main parts that investors and management need to understand clearly:

First Source: Cost of Debt (Cost of Debt)

When a company borrows money from banks or other financial institutions, it must pay interest at a specified rate. The cost of debt is not just the interest rate; since interest can be tax-deductible, the effective cost decreases after tax savings.

Second Source: Cost of Equity (Cost of Equity)

Besides borrowing, a company may receive investment from shareholders or owners. These investors expect a reasonable return commensurate with the risk level. The expected return rate is thus another form of capital cost.

How to Calculate WACC Using the Standard Formula

If a company funds itself from a single source, the calculation is straightforward. However, most companies use multiple sources simultaneously, requiring the WACC formula to compute a weighted average.

The WACC calculation formula is:

WACC = (D/V)(R_d)((1 - T_c)) + (E/V)(R_e)

where:

• D/V = proportion of debt to total capital
• R_d = cost of debt (interest rate)
• T_c = corporate income tax rate
• E/V = proportion of equity to total capital
• R_e = cost of equity (expected return)

This formula provides the weighted average of the costs based on the actual proportions of each source.

Example of WACC Calculation in a Real Scenario

To better understand, consider the case of ABC Company, a publicly listed firm with the following capital structure:

• Debt: 100 million THB (60% of total capital)
• Equity: 160 million THB (40%)
• Loan interest rate: 7% per year
• Corporate tax rate: 20%
• Expected return: 15%

Calculations:

D/V = 100/260 ≈ 0.3846
R_d = 0.07
T_c = 0.20
E/V = 160/260 ≈ 0.6154
R_e = 0.15

Plug into the formula: WACC = (0.3846)(0.07)(1-0.20) + (0.6154)(0.15)

WACC = (0.3846)(0.07)(0.80) + (0.6154)(0.15)

WACC = 0.02154 + 0.09231
WACC ≈ 11.38%

This calculation indicates that ABC Company should use a discount rate of approximately 11.38% to evaluate various investment projects. If the expected return from a project exceeds this rate, the project adds value to the company.

Using WACC to Assess Investment Worthiness

Once investors have the WACC value, they can compare it with the expected return:

• If the expected return exceeds WACC → the project is worth investing in
• If the expected return is less than WACC → the project is not worthwhile

In the ABC example, with a WACC of 11.38% and an expected return of 15%, since 15% > 11.38%, the project is considered valuable.

What Is an Appropriate WACC Value?

There is no universal “standard” WACC value, as it varies across industries and individual companies. However, the general principle is that a lower WACC is better because it reflects a lower cost of capital.

When making investment decisions, consider multiple factors:

• Industry characteristics
• Risk level of the project
• Company’s financing policy
• Overall economic conditions

Designing an Appropriate Financial Structure

Many companies aim to find the optimal capital structure to achieve two goals:

1. Minimize WACC – the lower, the better, enabling more efficient investments
2. Maximize Market Value of Equity – creating maximum benefit for shareholders

Methods include:

Using equity financing only: This tends to result in a higher WACC because shareholders face higher risk and demand higher returns.

Mixing debt and equity: This approach can lower WACC to an optimal level, as debt typically has a lower cost and interest is tax-deductible.

Limitations and Risks of Using WACC

While WACC is a useful tool, investors should be aware of its limitations:

Issue 1: Cannot predict future changes

WACC is calculated based on current data, but factors like interest rates, risk levels, and investment opportunities can change over time, making the calculated WACC potentially outdated.

Issue 2: Does not account for project-specific risk

WACC is an average for the entire company, but individual projects may have different risk profiles. Relying solely on WACC might lead to inappropriate decisions.

Issue 3: Complexity of calculation

Determining WACC requires extensive data, including current capital structure, costs of capital, and debt costs. Obtaining accurate, up-to-date information can be challenging.

Issue 4: WACC is an estimate

Due to many influencing factors, WACC is an approximation and may contain errors. It should be used alongside other analytical tools.

Using WACC Effectively

To maximize the benefits of WACC analysis, consider the following approaches:

First: Use WACC with other indicators

Don’t rely solely on WACC. Combine it with metrics like Net Present Value (NPV) which assesses the net value of a project, and Internal Rate of Return (IRR), which indicates the internal rate of return. Using multiple indicators leads to more balanced and accurate decisions.

Second: Regularly update WACC calculations

Financial data change over time. Regular updates ensure that the WACC reflects current conditions, especially when there are significant changes in interest rates, capital structure, or risk levels. This helps investors adjust their strategies timely.

Summary

WACC, or the weighted average cost of capital, is a crucial financial metric for investors and business managers. Understanding WACC allows for better evaluation of investment profitability, capital structure decisions, and comparison of different projects.

However, investors should not rely solely on WACC. They must understand its limitations and use it in conjunction with other financial analysis tools such as NPV, IRR, and other relevant indicators to make rational and appropriate investment decisions. A deep understanding of WACC meaning will help you become a smarter and more cautious investor.