Weighted Average Cost of Capital

When a company wants to build a new factory or develop a new product, it often needs a large amount of money. But where does that money come from? A company might raise money by issuing shares of stock, borrowing from a bank, or selling bonds to investors. Each of these methods comes with a cost. The cost of obtaining and using money to finance a business is called the cost of capital. When a company combines the costs of different sources of funding according to how much each source contributes, the result is called the weighted average cost of capital, or WACC. The name may sound complicated, but the basic idea is straightforward. WACC helps us understand the average return a company needs to earn to justify the cost of the money it uses. To understand how it works, let's first look at two common ways companies obtain money. The first method is issuing stock. When investors buy shares of a company, they become shareholders who own a portion of that business. The company can use the money it raises to fund its operations. Money provided by shareholders, along with earnings retained in the business, forms its equity. Shareholders are owners, not lenders. Unlike a bank loan, stock does not require the company to make fixed interest payments. However, this does not mean that equity is free. Imagine an investor considering putting $1,000 into a company. The investor believes that another investment with similar risk could provide an average annual return of about 10%. Naturally, the investor would expect a comparable return from this company. If the company's expected return is too low, the investor may choose to buy shares of another business instead. This means a company must consider the returns shareholders expect when using their money. The required rate of return is called the cost of equity. An important point is that the cost of equity is not necessarily an amount the company must pay shareholders every year. Shareholders may earn returns through dividends or increases in the stock price. The cost of equity represents the return investors require for providing capital and accepting the risks of ownership. The second method is borrowing money. Companies can obtain loans from banks or issue bonds to investors. Borrowed funds are called debt capital. Unlike shareholders, lenders have a contractual right to receive interest payments and repayment of principal. For example, if a company borrows $10 million at an annual interest rate of 5%, it would generally owe $500,000 in interest each year, assuming a simple fixed-rate loan. The interest rate a company pays on borrowed money is known as the cost of debt. In practice, the interest rate the company would have to pay to borrow money under current market conditions is particularly important. However, debt has a special characteristic when it comes to taxes. Under applicable tax rules, interest paid for business purposes may be deductible when calculating taxable income. Suppose a company pays $200,000 in annual interest and faces a corporate income tax rate of 25%. If the full amount is deductible and the company has enough taxable income to use the deduction, its tax bill could decrease by $50,000. After considering these tax savings, the effective interest cost would be $150,000. This is why WACC calculations generally adjust the cost of debt to reflect the tax benefit of deductible interest. Now let's consider a hypothetical company. Imagine a business that uses a total of $10 million in capital. Of that amount, $6 million comes from equity, while the remaining $4 million comes from bank loans and bonds. Suppose the company's cost of equity is 10%, its cost of debt is 5%, and its corporate income tax rate is 25%. We'll also assume it can fully benefit from the interest tax deduction. First, equity makes up 60% of the company's total capital. Multiplying the 10% cost of equity by 60% gives us 6%. Next, debt makes up the remaining 40%. The cost of debt is 5%, but after accounting for the tax benefit, it becomes 5% × (1 - 0.25) = 3.75%. Multiplying this by the debt weight of 40% gives us 1.5%. Finally, we add the two results: 6% + 1.5% = 7.5%. The company's weighted average cost of capital is therefore 7.5%. We can express this calculation with a general formula: WACC = Equity Weight × Cost of Equity + Debt Weight × Cost of Debt × (1 - Corporate Tax Rate) The equity weight and debt weight represent the proportions of a company's total capital provided by shareholders and lenders. In actual financial analysis, these weights are generally based on market values rather than simply the amounts recorded on the balance sheet. Analysts must also estimate the appropriate costs and tax rate. But what does a WACC of 7.5% actually tell us? It means the company has an estimated average cost of capital of about 7.5% when combining its equity and debt financing. If the company cannot generate sufficient returns on the capital it uses, it may struggle to meet the returns expected by its investors. Imagine that this company is considering building a new factory. Construction will require a large investment, but once the factory begins operating, it should produce goods that the company can sell for a profit. What happens if the factory generates a long-term return of only 5% on the money invested? The company's cost of capital is 7.5%, so the investment's return would be lower than the cost of financing it. Even if the factory reports an accounting profit, it may not generate enough economic value to satisfy the return required by investors. Now imagine the factory can consistently generate a 12% return instead. Assuming the project has a similar level of risk and the returns are measured consistently, earning 12% while facing a 7.5% cost of capital suggests that the investment could create value for the company. Of course, actual investment decisions are more complicated than comparing two percentages. A new factory may be riskier than the company's existing business, and cash may be earned or spent at different times. Companies therefore need to use a cost of capital appropriate for the investment and consider both the timing and amount of future cash flows. This raises another question. If debt usually costs less than equity, why doesn't a company simply borrow as much money as possible to lower its WACC? The answer is that excessive borrowing creates additional risks. Bank loans and bonds often have lower required returns than equity. However, the more debt a company takes on, the more interest it must pay and the more principal it eventually needs to repay. If the business performs worse than expected, meeting those obligations can become difficult. As financial risk increases, banks and bond investors may demand higher interest rates. Shareholders may also require higher returns because the company has become riskier. As a result, adding more debt does not necessarily keep reducing WACC. Borrowing at relatively low rates may initially lower the overall cost of capital, but excessive debt can eventually increase it. This is why companies must carefully decide how much of their funding should come from equity and how much should come from debt. The combination is called a company's capital structure. Another important point is that WACC differs from company to company. Consider a well-established business with decades of steady sales and profits. Investors may be willing to accept a relatively low required return because they believe the company is financially stable. Banks may also be willing to lend money at lower interest rates. Now consider a young company that is still developing its first product and has uncertain future revenue. Investors may demand a much higher return to compensate for the greater risk. The company may also have difficulty borrowing money or may face higher interest rates. Even if both businesses need the same amount of money, their costs of capital may be very different. Financial stability, growth prospects, business risks, market interest rates, and many other factors can affect WACC. So why should someone investing in stocks understand the weighted average cost of capital? One reason is that WACC plays an important role in estimating what a company is worth. A company's value does not depend only on how much profit it earns today. Investors also need to consider how much cash it might generate in the future, how reliable those future cash flows are, and how much capital the business needs to produce them. One common method of estimating a company's value is called discounted cash flow analysis, or DCF. This method estimates the present value of cash the company is expected to generate in the future. To understand the idea, consider receiving $1,000 today versus receiving $1,000 five years from now. These two payments do not necessarily have the same value. If you receive the money today, you could invest it and potentially earn additional returns. There is also uncertainty about whether a promised future payment will actually arrive. For these reasons, analysts use a discount rate to convert future cash flows into their equivalent value today. When valuing cash flows available to all providers of a company's capital, WACC is commonly used as the discount rate, provided it appropriately reflects the risks and financing structure involved. Generally, if everything else stays the same, a lower WACC increases the present value of future cash flows. A higher WACC decreases their present value. However, WACC is not a number anyone can determine with perfect accuracy. The cost of equity, in particular, is difficult to observe directly because it depends on the returns investors require in the future. Analysts must estimate it using financial models and assumptions. Two analysts examining the same company may therefore arrive at different WACC estimates. It is also important to remember that a low WACC does not automatically make a stock a good investment. If the stock is already expensive or the company's business prospects are deteriorating, investors could still experience disappointing returns. WACC is just one of many tools used to evaluate a business and its stock. Ultimately, the weighted average cost of capital reminds us that the money a company uses is not free. Capital provided by shareholders comes with an expected return, while money borrowed from lenders comes with interest obligations. For a company to grow and increase its value over time, simply reporting a profit is not enough. It must also earn returns that adequately compensate the people who provide its capital. WACC helps investors and businesses understand whether those returns are sufficient.