Definition of WACC
Weighted Average Cost of Capital is defined as the company’s cost of capital that is calculated using debt and equity. It can be defined as the minimum required rate of return for the company before the organization makes any new investment. It encapsulates the average cost of capital that the company obtains from various different sources including common stock, preferred stock, bonds, as well as other long-term debt.
In the same manner, it is very important to understand that organizations need to have a clear idea regarding the decision-making process before any investment is made. Therefore, it is important for the company to invest in any given project that has a rate of return that is higher than the generated WACC of any given project.
The company needs to invest in any given project that can generate a higher return as compared to the WACC of the company.
Formula for WACC
Weighted Average Cost of Capital (WACC) is calculated using the following formula:
WACC = RE × [Equity / (Debt + Equity)] + RD [Debt / (Debt + Equity)] × (1 – Tax Rate)
RE = Cost of Equity
RD = Cost of Debt
Equity = Market Value of Equity
Debt = Market Value of Debt
However, using this formula, there are a couple of assumptions that need to be kept in mind. These assumptions are as follows:
- Capital Structure remains the same – It is assumed that the capital structure of the company is supposed to stay the same over the course of time.
- Business Risk remains constant – It is also assumed that the business risk is likely to stay constant over the period of time, even after the project has been duly completed and accepted.
Advantages of using Weighted Average Cost of Capital (WACC)
WACC is a tool that is used by companies quite frequently. This tool is used by companies in order to ensure that they are able to get the best results that can facilitate better outcomes in the longer run. Factually, it can be seen that there are some very distinct and notable advantages associated with using WACC. These advantages are as follows:
- Ease of calculating: The fact that WACC can be easily calculated is one of the most prominent advantages of using this methodology. The information is readily available and accessible through the financial statements of the company. It does not require any complicated skill, and therefore, it can be used by professionals with a basic accounting background.
- Singular Ratio across all projects: The main reason behind calculating WACC is to draw a comparison between the existing rate of return of the company, and the project in consideration. The greatest advantage of using WACC stands to be the fact that it can be used across several different projects, and therefore, this ratio can be used single handedly to draw comparisons across different aspects. Hence, this ratio tends to be the go-to ratio for management accountants when preparing reports regarding the efficacy of a given project.
- Quicker decision making: Since it is easier to calculate, and can be used across various different projects, and hence, it results in quicker decision making on the part of companies.
- Merger and Acquisition Evaluation: When mergers and acquisitions need to be evaluated, financial models are prepared with based on the WACC. Therefore, all investment related decisions, even during mergers and acquisitions are contingent on calculations based on WACC.
- Since WACC is the minimum required Rate of Return, it can be termed as a hurdle rate for companies that needs to be crossed in order to generate values for the company.
Limitations of using WACC
Regardless of the fact that Weighted Average Cost of Capital tends to be one of the most widely sought approaches when making decisions (or valuing companies using the WACC approach), yet it can be seen that there are a handful of limitations associated with WACC that still need to be taken into consideration. These limitations are as follows:
- Lack of information: In the case of private companies, information regarding the debt and equity combination, as well as the rate of debt might not readily be available for external stakeholders. Therefore, it is quite challenging for external stakeholders to calculate WACC. Hence, it is a challenge for accountants to derive correct and proper information that is likely to depict an accurate picture of WACC for the users, to say the least.
- Changes in Capital Structure: WACC also assumes the fact that the capital structure of the company stays constant over a given period of time. However, capital structure constantly changes as debt matures, or any other equity is added on to the company. Hence, it is important for the accountants to realize the fact that Capital Structure tends to fluctuate with the course of time, and this, in return impacts the results that are derived from WACC.
- Alterations in WACC: Since WACC is contingent on debt and equity ratios of the company, it can be seen that it can be tweaked in accordance to the company itself. Therefore, it might not always be very reliable, because changing debt and equity ratios, or taking on more debt to tweak the WACC might result in a project being passed under the WACC approach, but not delivering actual positive returns in reality.
- Comparisons in similar risk situations: WACC uses equity and debt ratios, along with the respective cost of debt and cost of equity. However, it must be highlighted that WACC differs across various different companies, and various different organizations. Hence, WACC can only be compared within two companies if those companies have similar risk profiles.
Therefore, it can be seen that WACC is a highly resourceful tool that can be used by companies in order to enable them to make better decisions. Regardless of the fact that there are a handful of limitations of using WACC, yet the advantages of using WACC clearly outweigh the limitations. Hence, using this should be a no brainer for companies seeking to make better decisions based on WACC.