WACC is the weighted average of a company’s debt and its equity cost. Weighted Average Cost of Capital analysis assumes that capital markets (both debt and equity) in any given industry require returns commensurate with the perceived riskiness of their investments. But does WACC help the investors decide whether to invest in a company or not? To understand the Weighted Average Cost of Capital, let’s take a simple example. Suppose you want to start a small business! You go to the bank and ask if you need a loan to start. A bank looks at your business plan and tells you that it will lend you the loan, but there is one thing that you need to do. Bank says that you need to pay 10% interest over and above the principal amount you borrow. You agree, and the bank lends you the loan. You agreed to pay a fee (interest expense) to avail the loan. This “fee” is the “cost of capital” in simple terms. As businesses need a lot of money to invest in expanding their products and processes, they need to source money. They source money from their shareholders in the form of Initial Public OfferingsAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange.read more (IPO), and they also take a loan from banks or institutions. Companies need to pay the cost to have this large sum of money. We call this the cost of capital. If a firm has more than one source which they take funds from, we need to take a weighted average of the cost of capital WACC FormulaMany investors don’t calculate WACC because it’s a little more complex than the other financial ratiosFinancial ratios are indications of a company's financial performance. There are several forms of financial ratios that indicate the company's results, financial risks, and operational efficiency, such as the liquidity ratio, asset turnover ratio, operating profitability ratios, business risk ratios, financial risk ratio, stability ratios, and so on.read more. But if you are one of those who would like to know how weighted average cost of capital (WACC) works, here’s the formula for you. WACC Formula = (E/V * Ke) + (D/V) * Kd * (1 – Tax rate)  You are free to use this image on your website, templates, etc., Please provide us with an attribution link Article Link to be HyperlinkedFor eg: Source: Weighted Average Cost of Capital (WACC) (wallstreetmojo.com)
The equation may look complex, but it will begin to make sense as we learn each term. Let’s begin. Market Value of EquityLet’s start with the E, the market value of equity. How should we calculate it? Here’s how – Market Value of DebtNow, let’s understand the meaning of the market value of debt, D. How to calculate it?
Cost of EquityCost of DebtWACC Calculation – Basic ExampleAs there are so many complexities in WACC calculation, we will take one example each for calculating all the portions of the weighted average cost of capital. Then we will take one final example to ascertain the WACC. Let’s get started. Step # 1 – Calculating Market Value of Equity / Market Capitalization Here are the details of Company A and Company B – In this case, we have been given both the numbers of outstanding shares and the market price of shares. So let’s calculate the market capitalization of Company A and Company B.
Now we have the market value of equity or market capitalization of Company A and Company B. Step # 2 – Finding Market Value of Debt Let’s say we have a company for which we know the total debt. Total Debt (T) = US $100 million. To find the market value of debt, we need to check if this debt is listed. If yes, then we can directly pick the latest traded price. So, for example, if the trading value was $84.83 for a face value of $100, then the market value of debt will be $84.83 million. Step # 3 Calculate Cost of Equity
Cost of Equity = Rf + (Rm-Rf) x Beta Cost of Equity = 4% + 6% x 1.5 = 13% Step # 4 – Calculate the Cost of Debt Let’s say we have been given the following information –
Let’s calculate the cost of debt. Cost of Debt = (Risk Free Rate + Credit Spread) * (1 – Tax Rate) Or, Kd = (0.04 + 0.02) * (1 – 0.35) = 0.039 = 3.9%. Step # 5 – WACC Calculation So after calculating everything, let’s take another example of WACC calculation (weighted average cost of capital).
We need to calculate WACC for both of these companies. Let’s look at the WACC formula first – WACC Formula = E/V * Ke + D/V * Kd * (1 – Tax) Now, we will put the information for Company A, weighted average cost of capital formula of Company A = 3/5 * 0.04 + 2/5 * 0.06 * 0.65 = 0.0396 = 3.96%. WACC formula of Company B = 5/6 * 0.05 + 1/6 * 0.07 * 0.65 = 0.049 = 4.9%. Now we can say that Company A has a lesser cost of capital (WACC) than Company B. Depending on the return both of these companies make at the end of the period, we would be able to understand whether, as investors, we should invest into these companies or not. WACC Calculation – Starbucks ExampleAssuming that you are comfortable with the basic WACC examples, let us take a practical example to calculate the WACC of Starbucks. Please note that Starbucks has no preferred sharesA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation.read more and hence, the WACC formula to be used is as follows – WACC Formula = E/V * Ke + D/V * Kd * (1 – Tax Rate) Step 1 – Find the Market Value of Equity Market Value of Equity = Number of shares outstanding x current price. The market value of equity is also market capitalization. Let us look at the total number of shares of Starbucks –
Step 2 – Find the Market Value of Debt Let us look at the balance sheet of Starbucks below. As of FY2016, the book value of debt is current. As of FY2016, book value of Debt is the current portion of long-term debtCurrent Portion of Long-Term Debt (CPLTD) is payable within the next year from the date of the balance sheet, and are separated from the long-term debt as they are to be paid within next year using the company’s cash flows or by utilizing its current assets.read more ($400) + Long Term Debt ($3202.2) = $3602.2 million. source: Starbucks SEC Filings However, when we further read about Starbucks debt, we are additionally provided with the following information – source: Starbucks SEC Filings As we note above, Starbucks provides the fair valueThe fair value of an investment is the asset sale price that is agreeable to both the buyer and the seller. There is a caveat; the amount should be agreeable in a free trade scenario; there should be no external pressure or conditions.read more of the Debt ($3814 million) as well as the book value of debtThe book value of debt is the total amount the company owes, which is recorded in the company's books. It is used in liquidity ratios compared to the company's total assets to check if the organization has enough support to overcome its debt.read more. Therefore, in this case, it is prudent to take the fair value of debt as a proxy for the market value of debt. Step 3 – Find the Cost of Equity As we saw earlier, we use the CAPM model to find the cost of equityCost of Equity (Ke) is what shareholders expect for investing their equity into the firm. Cost of equity = Risk free rate of return + Beta * (market rate of return - risk free rate of return). read more. Ke = Rf + (Rm – Rf) x Beta Risk-Free Rate Here, I have considered a 10-year Treasury Rate as the Risk-free rate. However, some analysts also take a 5-year treasury rate as the risk-free rate. Please check with your research analyst before taking a call on this. source – bankrate.com Each country has a different Equity Risk Premium. Equity Risk Premium primarily denotes the premium expected by the Equity Investor. For the United States, Equity Risk Premium is 6.25%. source – stern.nyu.edu Beta Let us now look at Starbucks Beta Trends over the past few years. The beta of Starbucks has decreased over the past five years. This means that Starbucks stocks are less volatile as compared to the stock market. We note that the Beta of Starbucks is at 0.805x With this, we have all the necessary information to calculate the cost of equity. Cost of Equity = Ke = Rf + (Rm – Rf) x Beta Ke = 2.47% + 6.25% x 0.805 Cost of Equity = 7.50% Step 4 – Find the Cost of Debt Let us revisit the table we used for the fair value of debt. We are additionally provided with its stated interest rate. Using the interest rate and fair value, we can find the weighted average interest rate of the total fair value of Debt ($3,814 million) Effective Interest RateEffective Interest Rate, also called Annual Equivalent Rate, is the actual rate of interest that a person pays or earns on a financial instrument by considering the compounding interest over a given period.read more = $103.631/$3,814 = 2.72% Step 5 – Find the Tax Rate We can easily find the effective tax rateEffective tax rate determines the average taxation rate for a corporation or an individual. For both, there is a similar formula only with variation in considering variables. The effective tax rate formula for corporation = Total tax expense / EBTread more from the Income Statement of Starbucks. Please see below the snapshot of its income statementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more. For FY2016, Effective tax rate = $1,379.7 / $4,198.6 = 32.9% Step 6 – Calculate the weighted average cost of capital (WACC) of Starbucks We have collected all the information that is needed to calculate WACC.
WACC Formula = E/V * Ke + D/V * Kd * (1 – Tax Rate) = (86,319.8/90133.8) x 7.50% + (3814/90133.8) x 2.72% x (1-0.329) = 7.26% WACC InterpretationThe interpretation depends on the company’s return at the end of the period. If the company’s return is far more than the Weighted Average Cost of Capital, then the company is doing pretty well. But if there is a slight profit or no profit, the investors need to think twice before investing in the company. Here is another thing you need to consider as an investor. If you want to calculate the Weighted Average Cost of Capital, there are two ways you can use. The first is the book value, and the second is the market value approach. As you can see that if you consider the calculation using market value, it’s far more complex than any other ratio calculation; you can skip and decide to find the weighted average costAverage cost refers to the per-unit cost of production, calculated by dividing the total production cost by the total number of units produced. In other words, it measures the amount of money that the business has to spend to produce each unit of output.read more of capital (WACC) on the book value given by the company in their Income statement and in the Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more. But book value calculation is not as accurate as the market value calculation. And in most cases, market value is considered for the Weighted Average Cost of Capital (WACC) calculation for the company. LimitationsWACC is widely used in Discounted Cash Flow ValuationDiscounted cash flow analysis is a method of analyzing the present value of a company, investment, or cash flow by adjusting future cash flows to the time value of money. This analysis assesses the present fair value of assets, projects, or companies by taking into account many factors such as inflation, risk, and cost of capital, as well as analyzing the company's future performance.read more. As an analyst, we do try to perform sensitivity analysis in ExcelSensitivity analysis in excel helps us study the uncertainty in the output of the model with the changes in the input variables. It primarily does stress testing of our modeled assumptions and leads to value-added insights. In the context of DCF valuation, Sensitivity Analysis in excel is especially useful in finance for modeling share price or valuation sensitivity to assumptions like growth rates or cost of capital.read more to understand the fair value impact along with changes in WACC and growth rate. Below is the Sensitivity Analysis of Alibaba IPO ValuationAlibaba is the most profitable Chinese e-commerce company and its IPO is a big deal due to its size. With its huge size and network, Alibaba IPO may look at international expansion beyond China and may lead to price wars and intensive competition in the US.read more with two variables weighted average cost of capital (WACC) and growth rate. Some of the observations that can be made about WACC –
In the final analysisWACC is very useful if we can deal with the above limitations. It is exhaustively used to find the DCF valuation of the company. However, WACC is a bit complex and needs a financial understanding to calculate the Weighted Average Cost of capital accurately. Only depending on WACC to decide whether to invest in a company or not is a wrong idea. Investors should also check out other valuation ratios to make the final decision. WACC VideoRecommended ArticlesThis article has been a complete guide to WACC, formula, its interpretation, and the weighted average cost of capital examples. Here we also calculated the WACC of Starbucks and discussed its limitations and sensitivity analysis. You may also have at these articles below to learn more about valuations –
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Given the data in the above table, what is the weighted average cost of capital of this company?
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