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.
So, we need to take a weighted average of the cost of capital that accounts for all of these types of investors, so that we can look past the business’ decision to finance growth with different capital structures.
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 gross 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?
Basically, 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 $70,000 today? $80,000?
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, and the cost of equity is the dilution of ownership. If you borrow $10,000 for a year and agree to pay 10 percent interest, the cost of that capital is $1,000. If you borrow $10,000 in exchange for 1 percent equity in your business, the cost of that capital is the equity dilution.
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 senior debt investors, subordinated debt investors, preferred shareholders, and common shareholders.
Again, our objective is to understand the average cost of this capital and weight it to account for the different risk/required rates of return that these investors expect.
Weighted Average Cost of Capital = Cost of Equity + Cost of Debt