There are advantages and disadvantages of the weighted average cost of capital (WACC) which are discussed in details in the post coming ahead. The perfect understanding of the concept of WACC is a must for all finance professionals.
Corporations constantly keep track of the costs they incur. We all know that whenever costs are kept low, the profits jump and in turn, the value of your business increases indirectly. Similarly, like other costs, weighted average cost of capital as the name suggests is the cost which companies incur on their capital. Capital can either be debt or equity. Hence, WACC is one of the parameters which companies look at to increase the value of the firm. Lower the WACC, higher will be the value of the firm.
A Measure for Inter-Firm Comparision
You can compare the WACC of corporations having similar business risks. This will help you to know which corporation is using capital at the minimum costs. Note – the business risk is a possibility that a company may generate less than the required profits. This risk may prevent you from achieving your company targets. A business risk may differ from industry to industry and is mostly the same among a particular industry. A company having lower WACC compared to other companies operating in the same industry is an advantageous situation. It can create more value for its stakeholders.
Used for Valuing a Firm
WACC is used by valuation team for calculating the value of the firm. Are you wondering how? Let us understand with an example.
Free Cash Flow to Firm (FCFF) is the cash available to all debt and equity holders. Analysts use FCFF, growth, and WACC to calculate the value of the firm.
FCFF = $ 10,000, for simplicity we will assume that one expects to grow FCFF every year till perpetuity at the rate of 8%. WACC of the firm is supposing 12%. Value of the firm is as follows –
Value of the firm @ time t-1 = FCFF0 * (1+g) / (WACC – g)
= 10000 * (1.08) / (12%-8%)
=10,800 / 4%
As I have mentioned above (in the 1st point) that lower the WACC, higher would be the value of the firm. Note – FCFF0 = FCFF at Year 1. FCFF0 * (1+g) = FCFF @ Year 2.
A Criterion to Accept or Reject a New Project
Weighted average cost of capital guides the corporate finance team to judge whether to accept or to reject a project. In this process, IRR (Internal Rate of Return) is compared with the cost of capital of the firm to decide whether to accept or reject a project.
If IRR is greater than the cost of capital, the project can be undertaken or else the project is rejected. For e.g.: IRR = 15%, cost of capital (WACC) = 8%, IRR > Cost of capital, accept the project.
Used as a Hurdle Rate
WACC is the minimum rate of return the corporation must generate to satisfy its shareholders and its creditors. WACC, therefore, acts as a hurdle rate which the corporations have to cross to generate value to all shareholders and stakeholders.
Cost of Equity is Difficult to Calculate
Cost of debt (Kd) and Cost of equity (Ke) is to be estimated in the first place to calculate WACC. Ke is difficult to estimate for private companies because of lack of publicly available data. For the public companies the cost of equity calculation has various methods and which one to use has to be given a thought. There is no single formula that can be applied to every firm for calculating Ke. Since estimating Ke becomes difficult calculating WACC, in turn, becomes tough.
Unrealistic Assumptions: “D/E Mix will Remain Constant”
Debt/ Equity ratio will keep on changing and hence WACC will change. For the forecasting value of the firm, WACC is assumed to be constant which in turn means that debt/equity ratio will remain constant which is impossible. Using WACC carries an assumption that the debt to equity ratio remains constant.
Increasing Debt to Achieve Lower WACC is Problematic
WACC can be lowered by introducing debt on the balance sheet. Adding debt beyond the optimal capital structure in a pursuit to achieve lower WACC can increase your present value of the cost of financial distress more than the value of the levered firm. To understand this we need to first see how adding debt lowers the WACC. E.g. –
A firm has a 100% Equity. Equity = $1000, cost of equity (Ke) = 10%
Since there is no debt WACC will be equal to 10%.
WACC = (Equity/ Total capital) * (Ke) + (Debt/ Total capital) * (kd * (1-t)).
t= tax rate.
Now let’s say there is debt introduced on the balance sheet.
If Equity = $ 1000, Debt = $ 500, Ke = 8% , Kd = 6% , tax rate = 28% then according to WACC formula,
WACC = (1000/1500) * 8% + (500/1500) * 6% * (1- 28%)
= 0.6666 * 8% + 0.3333 * 4.32% = 5.3328 % + 1.4398% = 6.77%.
By introducing debt, WACC decreased from 10% to 6.77%.
Financial distress is when the company is having a difficulty in making payments to its creditors.
Cost of financial distress is the cost which a firm incurs beyond the cost of carrying day to day business operations. E.g. – if a company defaults on its payments then the goodwill of the company may be impaired because of which the company may lose its prospective customers. Present value cost of financial distress is the estimated distress cost discounted backward. Therefore, if a firm adds debt inadvertently then present value cost of financial distress may be more than the value of the levered firm. You may then lose the benefit of leverage and being company specific, you may also lose the advantages of WACC.