Weighted Average Cost of Capital
The weighted average cost of capital is calculated using 4 components: The after tax cost of debt, the cost of equity, the debt to capital ratio and the equity to capital ratio.
The company can take two approaches to attract capital:
- Attract equity investors who provide capital in exchange for business ownership
- Issue debt (bonds) borrowing funds from banks, corporation or individuals
Weighted Average Cost Of Capital:
The weighted average cost of capital is the average cost that a company is paying to its capital providers. The WACC formula is simply a company’s after- tax cost of debt weighted by the debt to capital ratio plus the cost of equity weighted by the equity to capital ratio.
Let’s look at an example that will work through the weighted average cost of capital formula:
Company B is a start up with no cash in hand. The company wants to fund an equipment plant in order to manufacture cell phones. The plant will cost 100M dollars. The company decides to fund this project with $60M of its own money (equity) which has a required return of 20%, and $40M with debt at a rate of 8%. Company B’s marginal tax rate is 35%. Using the WACC formula, calculate Company B’s weighted average cost of capital.
1) Company B’s cost of equity. This is given as 20%.
2) Equity to capital ratio: equity divided by total capital = 60/100 = 0.6
3) After-tax cost of debt: interest rate of debt times one minus the tax rate = 8% * (1-35%) = 5.2%
4) Debt to capital ratio: debt divided by total capital = 40/100 = 0.4
5) Weighted average cost of capital using the WACC formula
WACC = WACC = (A-T Cd * d/cap) + (Ce * e/cap)
A-T Cd = the after tax cost of debt
d/cap = the debt to capital ratio
Ce = the cost of equity
e/cap = the equity to capital ratio
WACC = (5.2% * .4) + (20% * .6)
= 2.08% + 12%
WACC = 14.08%
What does this all mean? Well, if the expected return of the equipment plant is greater than 14.08%, than the project will have a positive net present value. Therefore, the project should be accepted. However, if the manufacturing plant is expected to generate a return that is less than 14.08%, the net present value of the project is expected to be negative. The company will pay out more to its capital providers than it will receive in cash flow from the project. In this case, they would lose value by accepting the project. Therefore, WACC can be explained as the minimum acceptable rate of return that a company needs to receive in order to satisfy its creditors (lenders) and its investors (owners).
It is important to note the major difference in required return between the lenders (cost of debt) and investors (cost of equity). The lenders demand a lower return because they are taking less risk than the investors. We know the number 1 rule of finance “The greater the return, the greater the risk”. Let’s think about the different risks that the lender is taking vs. the investor. The lender is lending money and receiving a return as long as the company is solvent (not bankrupt).After the term of the loan is done, the lender will receive all of his capital back and will have made 8% on his money. Regardless,the lender will make his return as long as the company does not go bankrupt or becomes insolvent.
However, the investor (equity holder) is a part owner of the company. He will only make money on his investment if the company grows. This means that, if let’s say, the company loses 50M on his manufacturing plant. In this case, the lender would still receive his initial investment and interest payments. However, the investor would lose over 90% of his initial investment! Nevertheless, if the plant generates value for Company B, the lender will still only receive his 8% return… The investor’s returns are limitless!
From Company B’s perspective, they took on more risk by borrowing money than by attracting investors. Lending money increases Company B’s credit risk and risk of bankruptcy. For this reason, the company is paying a lower return to the lenders and a greater potential return to the investors (20% vs. 8%).
Thus, how does a company decide whether to borrow or attract investors? They must find their optimal weighted average cost of capital. The optimal weighted average cost of capital is the optimal capital structure (debt to capital and equity to capital ratio) that will provide the lowest WACC, without risking bankruptcy due to too much debt. So, there is an optimal balance of debt and equity for Company B that will provide the lowest WACC without risking bankruptcy. This is a more advanced calculation which requires statistics in order determine a company’s probability of bankruptcy. Once we master the weighted average cost of capital formula and process we will look at how to find the optimal WACC of any company.
Definition of cost of capital
In conclusion, calculating WACC is a relatively easy process when the information is given to you (just fill in the blanks in the formula). However, finding the information can be challenging. Continue to browse this website to find out more about analyzing a company’s cost of equity, before tax cost of debt, after tax cost of debt and finally how to operate your company at the optimal capital structure.