If you’re a business owner or finance professional, you’ve probably heard of the Weighted Average Cost of Capital (WACC). But what exactly is WACC and why is it important for your business? In this article, we’ll delve into the ins and outs of WACC and how it can be used to evaluate investment opportunities and assess the financial health of your company.
What is WACC?
WACC is a financial metric that represents the average cost of all the capital a company has raised to finance its operations and growth. This includes both debt and equity capital, with each type of capital carrying its own cost.
The cost of debt is relatively straightforward, as it is simply the interest rate that the company must pay on its borrowing. The cost of equity, on the other hand, is a bit more complex.
It represents the required rate of return that shareholders expect to receive on their investment in the company. This required rate of return takes into account the inherent risk of the investment, as well as the expected return on alternative investments with similar levels of risk.
How to Calculate WACC: A Worked Example
Now that we have a basic understanding of WACC, let’s look at how it is calculated using a simple example.
Let’s say that our fictional company, ABC Inc., has raised $10 million in capital. Of this capital, $6 million was raised through debt and $4 million was raised through equity. The interest rate on the debt is 6%, and the required rate of return on the equity is 10%.
To calculate ABC Inc.’s WACC, we would use the following formula:
WACC = (60% x cost of debt) + (40% x cost of equity)
Plugging in the numbers from our example, we get:
WACC = (60% x 6%) + (40% x 10%)
= 3.6% + 4%
This means that ABC Inc. has a WACC of 7.6%, which is the minimum return that the company must generate on its investments in order to meet the expectations of its shareholders and other capital providers.
Uses of WACC
Now that we know how to calculate WACC, let’s look at some of the ways it can be used:
1. Determine Minimum Return on Investments
As mentioned earlier, the WACC is the minimum return that a company must generate on its investments in order to meet the expectations of its shareholders and other capital providers. If a company is not able to generate a return that meets or exceeds its WACC, it may struggle to attract new capital and may even see its existing capital providers become disillusioned with the company’s performance.
2. Evaluate Investment Opportunities
WACC can also be used to evaluate the potential profitability of different investments and projects. By comparing the expected return on an investment to the WACC, a company can determine whether an investment is likely to be profitable or not. If the expected return on an investment is higher than the WACC, it is likely to be a good investment for the company. On the other hand, if the expected return is lower than the WACC, it may not be worth pursuing.
3. Assess Financial Health
In addition to its use in investment evaluation, WACC can also be used to assess the financial health of a company. A company with a high WACC may be perceived as being riskier and less financially stable than a company with a lower WACC. This is because a high WACC indicates that the company is paying a higher cost for its capital, which could potentially be a sign of financial distress or a lack of investor confidence. By comparing the WACC of different companies, investors and analysts can get a sense of their relative financial strength and risk levels.
In conclusion, the Weighted Average Cost of Capital (WACC) is a crucial financial metric that helps companies determine the minimum return they must generate on their investments and assess the profitability of different investments and projects.
It is also used to evaluate the financial health of a company and is an important factor in financial decision-making. Understanding and managing the WACC is an essential part of successful financial management for any business.
By following the steps outlined in this article and using a worked example, you should now have a good understanding of how to calculate WACC and how it can be used in your business. With this knowledge, you’ll be well equipped to make informed financial decisions and ensure the long-term success of your company.
- “Weighted Average Cost of Capital .” Investopedia. Accessed January 22, 2021. https://www.investopedia.com/terms/w/wacc.asp.
- “Weighted Average Cost of Capital.” Corporate Finance Institute. Accessed January 22, 2021. https://corporatefinanceinstitute.com/resources/knowledge/finance/wacc/.
- “Weighted Average Cost of Capital .” The Balance. Accessed January 22, 2021. https://www.thebalance.com/weighted-average-cost-of-capital-wacc-3977551.