A company is raising funds from different sources of finance and doing business with those funds. The company has a responsibility to give a return to its funding providers. If a company has only one source of financing, it is the rate at which it is required to earn from the business. However, the company may have raised funds from more than one source of finance, in which case WACC (Weighted Average Cost of Capital) must be found, which indicates the minimum rate at which the company should earn from the business to give a return to its finance providers, as per their expectations. Let’s see the importance of the weighted average cost of capital in detail.
The importance and usefulness of the weighted average cost of capital (WACC) as a financial tool for both investors and companies are well accepted among financial analysts. It’s important for companies to make their investment decisions and evaluate projects with similar and dissimilar risks. Calculating important metrics like net present values and economic value added requires the WACC. It is equally important for investors making valuations of companies.
- Importance and Uses of Weighted Average Cost of Capital (WACC)
- Important Inferences and Actionables from WACC
WACC analysis can be looked at from two angles—the investor and the company. From the company’s angle, it can be defined as the blended cost of capital that the company must pay for using the capital of both owners and debt holders. In other words, it is the minimum rate of return a company should earn to create value for investors. From the investor’s angle, it is the opportunity cost of their capital. If the return offered by the company is less than its WACC, it is destroying value. Therefore, the investors may discontinue their investment in the company and look somewhere else for a better return.
Importance and Uses of Weighted Average Cost of Capital (WACC)
The following points will explain why WACC is important and how investors and the company use it for their respective purposes:
Investment Decisions by the Company
WACC is widely used for making investment decisions in companies by evaluating their projects and various options. Let’s categorize the investments in projects in the following two ways:
Evaluation of Projects with the Same Risk
When the new projects have a similar risk level or the risk level is the same as the existing projects of the company; it becomes an appropriate and preferred benchmark rate to decide the acceptance or rejection of these new projects. For example, a furniture manufacturer wishes to expand its business in new locations, i.e., establishing a new factory for the same kind of furniture in a different location. To generalize this to some extent, a company entering new projects in its own industry can reasonably assume a similar risk and use WACC as a hurdle rate to decide whether it should enter into the project or not.
Evaluation of Projects with Different Risk
WACC is an appropriate measure to evaluate a project. However, WACC has two underlying assumptions. These assumptions are that the projects under discussion have the ‘same risk’ and the ‘same capital structure.’ What should one do in the situation where both these assumptions are not fulfilled? WACC can still be used with a certain modification regarding the risk and target capital structure. Risk-adjusted WACC and adjusted present value etc. are the concepts to circumvent the problems of WACC assumptions.
Discount Rate in Net Present Value Calculations
Net present value (NPV) is the widely used method of evaluating projects to determine the profitability of the investment. WACC is used as discount rate or the hurdle rate for NPV calculations. All the free cash flows and terminal values are discounted using the WACC.
Calculation of Economic Value Added (EVA)
EVA is calculated by deducting the cost of capital from the profits of the company. When calculating the EVA, WACC serves as the company’s cost of capital. This is how WACC may also be called a measure of value creation.
Valuation of Company
Any rational investor will invest time before investing money in any company. The investor will first try to determine the valuation of the company. Based on the fundamentals, the investor will project the future cash flows and discount them using the WACC; with that, the value of the firm can be calculated. From the Value of the Firm, value of debt will be deducted to find the value of equity holdings.
Value of equity will be divided by the number of equity shares issued by the company, leading to the company’s per-share value. One can simply compare this value and the company’s current market price (CMP) to decide whether it is worth the investment or not. If the valuations are more than the CMP, the scrip is said to be under-priced; if it is less than CMP, it is overpriced. For example, if the value is $25 and the CMP is $22, the investor will invest at $22, expecting the prices to rise to $25, or else investment will not be made.
Important Inferences and Actionables from WACC
Some important inferences from WACC can be drawn to understand various important issues that the management of the company should address.
Effect and Tweaking of Leverage
Considering the Net Income Approach (NOI) by Durand, the effect of leverage is reflected in WACC. Thus, the WACC can be further optimized by adjusting or changing the debt component of the capital structure. Therefore, the company can replace the high interest debts with lower interest rates. It would lower the WACC. Lower the WACC will lead to higher earnings for the company. And that will further lead to higher valuations of the company. A lower WACC also widens the scope of the company by allowing it to accept low return projects and still create value for the stakeholders.
Optimal Capital Budgets
The increase in the magnitude of capital also tends to increase the WACC. With the help of a WACC schedule and project schedule, an optimal capital budget can be worked out for the company to arrange proper and synchronized utilization of the capital.
Any analysis using WACC should also consider the advantages and disadvantages of WACC.
WACC is an important metric used for various purposes. It sets the tone clearly wherein it is the minimum hurdle rate or the lowest bar. And a business must earn over and above this rate or this bar to remain in the business. If the business can achieve or launch a project with a higher than this rate, it is always preferred. However, it must be used very carefully. The weights of the capital components should be expressed in market value terms (Refer: Market vs. Book Value WACC). The market values should be determined carefully and accurately. Faulty calculations of WACC will also result in faulty investment decisions. This metric has certain concerns also, such as no consideration given to the floatation cost, which should not be ignored. The complications further increase if the capital consists of callable, puttable or convertible instruments, warrants, etc.
Quiz on Importance and Use of Weighted Average Cost of Capital(WACC)