Put simply, the Weighted Average Cost of Capital (WACC) is the percentage rate of return a business needs to generate in order to compensate, on average, both the debt and equity capital providers to the business.
The principles supporting the calculation of WACC are rooted in finance and valuation theory. Despite much academic literature on the limitations of the assumptions underpinning the theory, the use of WACC is widely accepted to be appropriate in practice, particularly in respect of valuing listed entities as well as in commercial and regulatory decision making.
The calculation of WACC is commonly determined using the following formula:
Kd x D/(D+E) + Ke x E/(D+E) where:
Kd = the cost of debt
Ke = the cost of equity
D = the market value of debt
E = the market value of equity
The cost of debt can be obtained from analysis of financial statements and reviewing agreements in respect of interest bearing debt held by the firm. As the interest expense on debt is generally tax deductible, this should be taken into consideration in determining the cost of debt.
The cost of equity is typically derived using the Capital Asset Pricing Model (CAPM) which is based on the following formula:
Rf + β(Rm – Rf) where:
Rf = a risk free rate, which might be obtained by reference to a treasury bond as an example;
Rm – Rf = a risk premium, which is the difference between the expected return on a diversified market portfolio and the risk free rate. There are numerous studies conducted by research academics in Australia which report on the long run average market risk premium which can be adopted; and
β = a Beta factor, which is the measure of risk relative to the market that cannot be diversified.
Upon obtaining the two key capital components being the cost of equity and the cost of debt (Kd), the final step in determining the WACC is to apply the weighted average to each to each capital component.
Mechanically speaking, the calculation of WACC is fairly straightforward. However, in practice, there is a significant degree of judgement required in calculating a WACC. For example, some of the judgement calls involve:
- conducting a company and/or industry comparative analysis where Beta data is not available;
- adjusting the available Beta data on the basis that the historic observations may not be indicative of future expectations;
- matching the time frames for the risk free and risk premium rates to the time period relating to the relevant cash flows which are going to be subject to WACC calculation; and
- assessing the firm’s optimum gearing level, which may be significantly different from its actual gearing for the purposes of applying a weighted average.
It is not uncommon for two experts to arrive at different WACC estimates for a particular listed company, the implications of which can be material. A significant degree of diligence and rigour is required in attempting to estimate a WACC for a non-listed company or a part of a conglomerate listed company . Despite its prevalence in practice, one could reasonably argue that applying the above WACC derived rate of return for smaller, owner-managed business may result in absurd outcomes.