Weighted average cost of capital (WACC) is an important concept in professional financial analysis, used both by internal analysts at firms looking to make investments and by external analysts looking at whether firms are effectively investing capital in new money-making ventures. The basic concept is that a company can raise capital through a variety of methods (from both debt and equity sources), and it will vary according to external and internal factors. A number of methods are used by firms to lower their WACC, the primary of which are keeping a low credit rating (which helps lower debt’s WACC), keeping a high value in equity markets (which helps lower equity’s WACC), and using either debt or equity when it is most economically feasible and at the lowest cost for the firm.

The formula for calculating WACC, which you can see on Wikipedia and several other financial sites, depends on market value of all outstanding securities, the firm’s total debt, shareholder’s equity, cost of equity, and cost of debt. Lower cost of equity and cost of debt will make for a lower WACC, which in turn will make a firm more valuable and give it a potentially higher rate of return on future investments.

The WACC method of analyzing a firm’s cost of capital is preferred, although it is not used exclusively, because of its ease of use.

For instance, if we imagine a firm that has the following balance sheet, we can quickly determine its cost of capital:

  • Debt: $100 million
  • Equity: $200 million
  • Total Market value: $500 million
  • Cost of equity: 8%
  • Cost of debt: 5%

Firstly, let’s bear in mind that the CoE and CoD metrics are exogenous; that is, they depend on external factors. A higher return in stocks outside of the firm will require a higher CoE for the company; similarly, a higher return on bonds or a higher interest rate (an important consideration now that the Federal Reserve is raising interest rates) will cause the CoD to increase. These are also somewhat subjective; every investor will have a different expectation, and firms may underestimate or overestimate the actual return investors want. An analyst’s job partly depends on finding the most accurate number for these variables as is possible.

The other figures are the result of a GAAP accounting of the firm’s balance sheet, and thus are much less subjective. When we have these factors calculated, we can then figure the WACC thus:

WACC = (100m/100m+200m)0.05 + (200m/100m+200m)0.08

Some quick math tells us that this firm’s WACC is 7%.

If we perform this calculation across a number of companies within the same sector with similar growth rates, we can determine which have a lower WACC. We can then take a look at which firms are using debt and equity markets to invest in future growth and determine whether these investments are going to provide a strong return or not.

This is an essential bit of fundamental analysis, because many firms will invest in expansions to please shareholders even if the rate of return on those investments does not exceed the WACC by a sufficient measure. Furthermore, a WACC analysis can also tell us whether the firm can provide shareholders with a higher rate of return by, instead of investing in new operations, simply returning capital to shareholders in the form of dividends or stock buybacks.

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