Understanding the weighted average cost of capital

The weighted average cost of capital (WACC) is a measure of proportional capital cost to businesses and corporations seeking an assessment of multiple forms of capital infusion. For example, if company A issues corporate bonds, shares and takes on loans it incurs multiple sources of capital. Since the amount and percentage of capital varies with each type of capital it's cost must be determined using a specific calculation, namely the weighted average cost of capital.

Key attributes of the weighted average cost of capital

The weighted average cost of capital serves as a financial tool for financial managers, business analysts, accountants, shareholders and others. The WACC equation is a metric that facilitates financial positioning within the time period represented by the numbers used in the equation. In other words, sudden changes in interest rates, price to earnings ratios, and market conditions may not be reflected in WACC calculations. Some of the features of the WACC calculation are as follows:

• Assists in determining capital leveraging cost
• Aids financial analysts in streamlining corporate budgets
• Shareholders, strategic planners & others determine financial positioning
• Provides a meaningful method to compare cost competitiveness 
• Defines percentage cost for a given set of capital components
• Is also used in determining Discounted Cash Flow (DCF)

How to calculate the weighted average cost of capital

To calculate WACC one needs to know the percentage proportion of each form of capital, the dollar amount and each components cost. For example, Company A may have a 4th quarter capital distribution of 25% Corporate bonds, 40% common stock, 10% preferred stock and 25% business loans. Each of these forms of capital have different costs. Moreover, the corporate bonds may cost 6% in interest, the common stock may cost 12% return including dividends, 14% for the preferred stock and 5% for the business loan(s). Using these percentage costs, they can be entered into the following WACC equation.² 

Step 1: Cost of Equity: If issued shares are a component cost of WACC a cost of equity calculation can be used to determine its cost. Calculating cost of equity can be achieved in a number of ways, two of which include the 1) Capital asset pricing model, 2) dividing dividends plus expected return by market price¹ and 3) Expected shareholder return. Additionally, if the share are new issues, the cost of equity can include investment bank fees and costs associated with the issue.

EX: Shareholders of company A expect an $1.10 return on an $11.00 stock making the 'cost of equity' $1.10/$11.00=10%. If company A also issues dividends, the dividend cost is added to the expected shareholder return i.e. a .20 cent annual dividend + $1.10=$1.30/$11.00=11.8%

Step 2: WACC=%Weight of component 1 (1-T) + % weight of component 2 (component 2)+ % weight of component 3(component 3)+% weight of component 4 (1-T) where T= 10% tax cost reduction or 90% of bond and loan debt.

Thus, WACC=.25(6%)(.9)+.40(12%)+.10(14%)+.25(5%)(.9)
=.25(5.4%)+.4(12%)+.10(14%)+.25(4.5%)
=1.36%+4.8%+1.4%+1.125%
WACC=8.685%

Advantages and disadvantages of WACC 

Of particular relevance to the weighted average cost of capital is the cost of equity value. Since market price of equity is not generally static, the true cost of capital varies and since investors expectations vary the cost of capital may not be an exact figure. However, the WACC calculation is useful in determining a strong estimate if not an exact cost of capital leveraging. Ideally, the lower the WACC percent is, the better for the company. The WACC calculation can also serve as a metric to compare against a cost benchmark.

However, it is also important to note how the numbers in the WACC equation can be somewhat misleading. For example, if a manager at Company A decides WACC is too high and consequently pays off a loan using retained earnings, the loan portion of the WACC calculation will decline assuming no other loans are taken. This could actually increase the cost of capital as the remaining capital may be in a higher cost equity leveraging. Thus, WACC should not be considered an operating cost but rather a measure of capital distribution and the cost associated with that distribution of that funding.

Additionally, if corporate performance, market and economic conditions are favorable the company's valuation may rise causing WACC to change for the better if shareholders expectations do not adjust. If loan debt is variable rather than fixed, changes in the interest rate of such debt can also cause fluctuations in WACC. Henceforth, being aware of the terms, conditions, context and environment of capital costs is essential in interpreting the result of the WACC calculation.

Summary

In Summary, the weighted average cost of capital (WACC) is a metric used in finance to quantify percentage distribution of cost for more than one non-equal sources of capital. The measurement helps businesses ensure adequate cash-flow, assists with debt management decisions, and provides a quantitative value with which to evaluate financial decisions. In essence, the average is 'weighted' based on the proportional amount of each type of capital. WACC can be calculated using a tax deduction for after tax cost of capital and may include a cost of equity component which itself can be calculated in more than one way. 

For these reasons and changes in cost conditions, a WACC calculation may have a short expiration in terms of validly and accurately representing capital cost(s). Nevertheless, the WACC calculation is useful in determining how a company is financed, and what that capital costs. The WACC calculation serves as an indicator, benchmark, and guide to financial practitioners seeking to gain a more accurate understanding of corporate capital structure.

Sources:

1. http://www.investopedia.com/terms/c/costofequity.asp
2. Eugene F. Brigham and Michael C. Ehrhardt. "Financial Management: Theory and Practice 10th Ed." Southwestern. 2002 p.420-422.
Eugene F. Brigham, and Joel F. Houston. Fundamentals of Financial Management 9th Ed. South-Western, 1999.p277-281.

The difference between marginal and weighted average cost of capital

As the names imply, both Weighted Average Cost of Capital (WACC) and Marginal Cost of Capital measure cost of capital. Capital is any money used to finance a business and/or its operations and can include a number of sources and methods. These sources may include traditional debt or equity financing or owner financing. Other forms of financing include grants, gains on investment capital, retained earnings, accrual financing contracts and forward payment agreements on capital.

Marginal cost of capital

Different types of capital are used in different amounts and for different costs. It is the costs of capital that is marginal and may involve or include a basic interest rate cost structure. For example, if Company A acquires a loan for $100K at an interest rate of 7% for one year, compounded annually, that capital will cost $7K. 

A simple average cost of capital may not accurately represent the true cost of capital for a company. For example, if Company A is financed by 1) $100K of debt at 7%, 2) $50K of equity at 12% and 3) $75K of owner financing at 0%, the average cost of capital would be 7% + 12% + 0% divided by 3=%19/3=6.33%. However this cost is not accurate because it does not take into account the different amounts of money at the different rates. In order to amend this discrepancy in calculation, the weighted average cost of capital is used.

Weighted average cost of capital

Weighted average cost of capital multiplies the amount of capital by the percent rate of cost for that capital as a proportional percentage of total capital and then averages 2 or more costs that are calculated in the same way. This can be further understood by dividing the previous sentence into two concepts 1) average amount of total capital and 2) percentage cost of capital type. Using the above example concept 1 is illustrated below:

Concept 1: Average Amount of Total Capital

If 3 types of capital are used; one at 44.44% of total capital, two at 22.22% of capital, and 3 at 33.33% of total capital the three added together add up to 99.99% of total capital. These 3 percentages are the proportions by which each rate of capital cost must be multiplied by in order to obtain the weighted average cost of capital.

Concept 2: Percentage Cost of Capital

The percentage cost of capital takes the marginal cost of capital and multiplies that by the proportional cost of capital. To continue illustrating with the above example, Company A uses $7K at 7% of debt at 44.44% of total capital that equals a proportional rate of 3.11%. Using the same reasoning for the $50K of equity at 12% and $75K of owner financing at 0%, WACC becomes 3.11% + 2.66% + 0%=5.77%/3=1.9233%. So the weighted average cost of capital is 1.9233% and is a more accurate representation of Company A's cost.

Summary

Marginal cost of capital and weighted average cost of capital a cost values that help a company manage its capital budgeting and asset management operations. Without knowing cost of capital, a company is less able to determine what rate of return projects and investments are required in order to break even, or surpass initial cost to acquire a profit margin. Marginal Cost of Capital may involve less calculation than WACC, however marginal cost may be calculated by incorporating tax rates, overhead, insurance or any other cost associated with acquiring the particular capital.

Marginal cost of capital can be included in the weighted average cost of capital calculation because each type of capital when weighted itself has marginal cost. Thus, marginal cost of capital and weighted average cost of capital are not necessarily mutually exclusive. Moreover, weighted average cost of capital generally cannot be a component of marginal cost of capital whereas the inverse is true for marginal cost of capital. Marginal cost of capital and WACC are important cost variables used in finance, accounting, project management, strategic management in addition to non-corporate analysis of the company such as in auditing, investment analysis, tax regulation and external financing.

Why the Weighted Average Cost of Capital is Used

Weighted Average Cost of Capital (WACC) is used to assess the value of, and return on investment of corporate operations such as project management. Said differently, the weighted average cost of capital is used to assess cost, compare profit, and in asset allocation decisions. WACC is a calculation that serves as a financial management tool to more accurately determine the fiscal benefits of capital asset management. For investors, the weighted average cost of capital can be used to in financial analysis of a potential investment or in distinguishing between investment opportunities.

To illustrate how weighted average cost of capital is used, consider a small landscaping business called Lad's Landscaping that wants to purchase a wood chipper using a combination of debt, and shareholder capital. The proceeds from the chipped wood should be profitable enough to cover the cost of the debt and equity. It should also be more profitable than available alternatives that meed the same demand for chipped wood.

The weighted average cost of capital, when used in conjunction with the Net Present Value (NPV) of future cash flows should yield a viable estimate of profit provided the future cash flow itself is accurate. Moreover, to understand how the weighted average cost of capital is used, the above example of Lad's Landscaping can be expanded upon. If the cost of the Wood chipper is $750.00, debt financing is $300.00 at five percent and equity financing is $400.00 at twelve percent with the remainder paid in cash what is the weighted average cost of capital?

Weighted average means proportional averaged cost; since $300.00 in debt is used to finance the wood chipper and the total cost is $750.00 then, $300.00/$750.00 is 40 percent. Similarly the equity portion of the cost is 53 percent. Consequently, the weighted proportion for each is the percent of total cost divided by the total percent i.e. 40 percent / 95 percent equals a weighted 42.1 percent weighted proportion of debt multiplied by the cost of five percent which is 2.1 percent. Similarly, the proportional cost of equity is 6.69 percent making the total weighted average cost of debt and equity 8.79 percent.

Even though cash poses no immediate cost, there may also be opportunity costs associated with the use of cash. For example, what if the landscaping used the $50.00 to advertise instead? Would the return on advertising lead to a return on cost greater than had the $50.00 been used for the woodchipper? Since return on advertising would have to be correlated with before and after dependent and independent variables, unless similar data exists from a previous advertising campaign, the cost would be an estimate.

Since corporations may deduct interest payments on debt, tax percentage may also be subtracted from the weighed average cost of debt i.e. 2.1 percent and are often used in WACC calculations by multiplying the resulting proportional cost percentage by 100 percent minus a tax percentage. Thus, 2.1 multiplied by 25 percent or .25 is 1.575 percent making the total cost after tax 8.265 percent.

In the above example, we know the weighted average cost of capital for the wood chipper is 8.265 percent which in and of itself is not as useful unless compared against revenue and other investment options. For example, if the projected average future cash flow from wood chipper services and rentals is $6000 per year how much does the wood chipper yield? This depends on how long the wood chipper is financed. If it is perpetual, the weighted average cost of capital can be used as an expense i.e. $6000.00 x 8.265 percent is $495.90 for $5,504.10 per year.

The above earnings estimate does not include overhead and additional company expenses making WACC somewhat limited unless it also adds additional costs after being calculated. Even so, if the same WACC calculation is used for another investment such as a snow plow, and future cash flow is accurate, then the two costs can be compared against projected revenue to distinguish between the financial benefits of the snow plough versus the wood chipper.

Moreover, even if total cost on average goes up by purchasing a higher cost snow plough, total earnings for the landscaping company can rise despite a lower profit margin. Since higher earnings somewhat trump profit margin, the weighted average cost of capital can be used to see how much profit margin would shrink if the more expensive snow plough is purchased in addition to the wood chipper.

Sources:
1. http://bit.ly/9azJx6 (Value Based Management)
2. http://bit.ly/926bUg (QFinance)