Corporate Finance
Feb 20, 2023
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This guide explains what weighted average cost of capital (WACC) is and explains how it is used in business valuation. Here are some key takeaways about weighted average cost of capital:
The key to understanding weighted average cost of capital is understanding the risk to the investors that provide capital to businesses.
When businesses need money for growth, but don’t have the ability to pay for that growth out of cash flow from operations, they will seek to raise outside capital to fund that growth instead.
Investors invest in businesses in two ways—debt or equity.
Debt investors lend the business money in exchange for interest payments and the future return of the loaned amount. Equity investors give businesses money in exchange for an ownership stake in the business.
There are different types of debt investors and there are different types of equity investors. To learn more about the distinctions, we recommend our guide: Capital Stack Quick Guide.
Capital stack is a term that refers to how a business is financed. The capital stack is a breakdown of a business’ capital structure. It breaks the investors down into categories based on their liquidity position. Here is an infographic showing a breakdown of the capital stack:
Senior debt providers have the highest liquidity position, meaning that they get paid back first in the event of a sale or liquidation. Next, subordinated debt investors have a lower liquidity position than senior debt providers, but higher than equity investors. Last, we have equity investors that are paid back after all of the business’ debt has been repaid. If the business can’t repay all of it’s debt, they will receive no pay out in the event of a liquidation.
With this difference in liquidity position comes increased or decreased risk.
The equity investors won’t be paid back in the event that the business can’t pay its debt. The higher the liquidity position, the higher the claim the investor has to the business’ cash flows, and therefore the lower the risk of their investment. The same is true the other way around. The lower the liquidity position, the lower the claim those investors have to the business’ cash flows, and therefore the higher the risk to these types of investors.
These investors also typically have required rates of return that correspond to these liquidity positions in order to justify the risk. Common stock investors require the highest rate of return on their investment in the business. Term loan providers require less of a return. As debt investors descend in liquidity position, the higher the interest rate they charge for loans.
These various liquidity positions mean that some investors get paid back before others. When we’re doing a DCF valuation of a business, we need to look at the cash flows that are available to all capital providers and we need to use a discount rate that also accounts for all capital providers.
Weighting the average cost of capital is a measure taken to account for these differences. We use WACC as the discount rate (r) in a DCF valuation.
Ultimately the decision to finance growth with debt vs equity is up to the management of the business. Many things influence this decision and here, we’ll look at why we want to look past it when trying to value the business.
Without disregarding capital structure, it’s difficult to compare two companies together. Let’s look at an example to better understand this: two companies that are both doing $10 million in revenue, and 20 percent in profit before the decision to raise capital. Company A financed their growth entirely with debt, and Company B financed their growth entirely with equity. In this case, after raising capital, the company’s income statements would look different. Company A would have lower profit margins (because they need to make interest payments) until they paid off their debt. But in looking beyond that temporary decision to finance growth with debt, two years later, Company A may actually have made better use of their new capital and could now be more efficient in operations than Company B.
So, we would want to look past how a company is financed when trying to value the business, so that we are using apples-to-apples comparisons. After all, if we were to buy 100 percent of a business, we wouldn’t care that we were buying out two shareholders instead of one (Company B’s circumstance), and we would want to see how Company A would perform a few years later when the loan was paid off.
As we’ve just seen, we’re looking to use the weighted average cost of capital so that we can deliberately disregard a business’ capital structure so we can gain more insight into operations and make better comparisons to other businesses in the company’s industry. Capital structures often change over time, in conjunction with the business’ life cycle.
As we’ve seen, the weighted average cost of capital is used in discounted cash flow (DCF) valuations. A DCF valuation tells us the enterprise value of the business. A business’ enterprise value is the value of the business without giving consideration to it’s capital structure. In order to do this, we need to use the right cash flows (cash flows that are available to all capital providers), and we need to discount them back in time at a rate that gives consideration to the cost of capital for all capital providers.
Normally, we use the weighted average cost of capital as the discount rate in a DCF valuation.
To learn more about how to do a DCF valuation of a business, we recommend our guide: Discounted Cash Flow (DCF) Valuation. In that guide, we look at the concept of discounting.
Here, we’ll look at the concept of discounting cash flows.
If I were to give you $100,000 in ten years’ time, how much would you pay for this today?
Your answer would have to depend on the perceived risk of me actually paying you the $100,000, your opportunity cost in investing this way versus another, and your assumptions about how much $100,000 ten years from now would be worth in today’s dollars.
Would you pay $50,000 today? $60,000?
With a DCF valuation of a business we’re really trying to think through the same concepts, but we have to give consideration to the fact that valuing businesses is more complex than the example above.
When we do a DCF valuation of a business, we’re looking at the business’ expected future cash flows and we’re discounting them back in time to their net present value (what they are worth paying for today.) In order to do this, we use the unlevered free cash flows (the cash flows available to all capital providers) and we discount them back in time at the weighted average cost of capital (taking into account all capital providers). This tells us the enterprise value of the business—what the business is worth without giving consideration to it’s capital structure.
With the enterprise value of a business, we can compare it to other businesses and see an apples-to-apples comparison.
Now that we understand the concept of weighted average cost of capital, and how this fits into a DCF valuation, we’ll look how to calculate a business’ WACC.
First, understand that the cost of debt is the interest rate that needs to be paid on the amount borrowed and the cost of equity is the dilution of ownership stake in the business. What we're going to do is calculate the cost of debt and the cost of equity, and then calculate the weighted average cost of these.
This is an oversimplification of WACC, but is valuable in understanding the concepts we'll cover in more detail here.
When we’re using a weighted average cost of capital in a business valuation, we need to expand on that simple concept to account for the fact that the business may have a much more complicated capital structure that could include publicly issued bonds, senior debt investors, subordinated debt investors, preferred shareholders, and common shareholders.
It's useful to look at calculating WACC in three steps:
First, we'll look at how to calculate the cost of debt.
Debt financing can be complicated, especially when we get into bonds. To make is simpler, the cost of debt is the after tax yield on a company's debt (not the coupon rate). You can calculate it as: yield x (1-tax rate). A simple way to look at yield is the amount that investors will make on the principle value of their investment. This would be the interest portion of a loan. It is important to look at this from an after tax perspective because interest expense is normally tax deductible and we want to make sure that WACC is an unlevered metric.
Second, we'll look at how to calculate the cost of equity.
The cost of equity is usually calculated using the Capital Asset Pricing Model (CAPM). Accurately calculating the cost of equity is one of the hardest parts of a DCF valuation.
The basic CAPM calculation is: risk-free rate + (beta x equity risk premium).
The CAPM is made up of three components, the risk-free rate, beta, and our equity risk premium.
For the risk-free rate, we would normally use the yield on a long-term government bond from a highly-rated economy (like the USA). It is presumed to be a risk-free rate because should the government ever be unable to pay this, it could "print" the money to do so. You can lookup the yield on long-term government bonds.
Since the risk-free rate is risk-free, it will have a lower required rate of return than an investment in a business (because there is always some level of risk in this investment).
Because of this, we need to add a premium to the risk-free rate. This will make up the second part of our equation (the part in parenthesis above). This "premium" we add is normally comprised of two components: beta and our equity risk premium.
Beta is defined as the output of a statistical regression that measures a stocks return versus the return of the overall stock market. Beta is market specific risk and it normally looks at things like interest rates, inflation, the business' economic cycle and the impact of legislation. You can look at beta for specific industries. If you are new to valuation, you could look up beta for your industry, however there is a lot of room for error in DCF valuations and we would recommend seeking out professionals to assist you if you are valuing your business for any specific reason.
The equity risk premium is the return of the stock market over and above risk free rate. equity risk premiums usually fall somewhere between 4 percent and 8 percent, historically.
Third, we'll take a weighted average of both of these costs.
We can do this as follows: (weight of debt x cost of debt) + (weight of equity x cost of equity).
Remember that this is an unlevered metric, so it needs to account for the cost of capital from all debt providers and from all equity providers.
Now that we've broken down how to calculate WACC, here is a formula for some more perspective:
Again, our objective is to understand the average cost of this capital and weight it to account for the cost to all capital providers.
Believe it or not, the entire formula above goes into the little part in the denominator, (r) in the DCF formula below.
