The average cost of capital (WACC) Comprehensive explanation

Why Is It Important to Understand WACC

Many investors face the challenge of deciding which projects are worth investing in. Considering only the expected returns may not be sufficient to evaluate profitability, as they need to be compared with the cost of capital used for the investment. Therefore, understanding the WACC or the (Weighted Average Cost of Capital) becomes essential for making smart investment decisions.

What Is WACC and How to Understand Its Meaning

WACC stands for Weighted Average Cost of Capital, which means the overall cost calculation that a company must incur to raise funds for operations, whether from borrowing or from shareholders’ investments.

The WACC value helps investors understand how much it costs the business to raise capital. The lower the WACC, the more the company can raise funds at a lower cost, which is a good sign for investment.

Structure of WACC: Main Components

WACC consists of two natural sources of capital costs:

Cost of Debt(

Cost of debt refers to the expenses the company must pay to borrow money from banks or financial institutions, expressed as an interest rate. For example, if a company borrows at an interest rate of 7% per year, that is the company’s cost of debt. Additionally, tax benefits should be considered since interest expenses are tax-deductible.

) Cost of Equity###

This component is the expected return that shareholders anticipate from investing in the company. Shareholders require a higher return than the cost of debt because they bear greater risk.

How to Calculate WACC Step-by-Step

When a company raises funds from a single source, the cost of capital is that source’s cost. But if funds come from multiple sources, a weighted average must be calculated using the formula:

WACC = (D/V)(Rd)(1-Tc) + (E/V)(Re)

where:

• D/V = proportion of debt relative to total capital
• Rd = cost of debt (interest rate on loans)
• Tc = corporate income tax rate
• E/V = proportion of equity relative to total capital
• Re = expected return demanded by shareholders

Example of Applying WACC in Investment Decisions

Suppose ABC Company has the following capital structure:

• Debt: 100 million THB (60% of total capital)
• Equity: 160 million THB (40% of total capital)
• Loan interest rate: 7% per year
• Tax rate: 20%
• Expected return: 15%

Calculations:

• D/V = 100/260 = 0.385
• E/V = 160/260 = 0.615
• WACC = (0.385)(0.07)(1-0.20) + (0.615)(0.15)
• WACC = (0.385)(0.07)(0.80) + (0.615)(0.15)
• WACC = 0.0215 + 0.0923
• WACC = 0.1138 or 11.38%

Since the expected return (15%) exceeds the WACC (11.38%), this project is considered attractive and worth investing in.

What Is a Good WACC Value?

A low WACC indicates a low cost of capital, which is a positive sign. However, other factors should also be considered, such as the industry in which the company operates, project risk, and the company’s investment policy.

Decision criteria:

• If the expected return > WACC → the project should be invested in
• If the expected return < WACC → the project should not be invested in

Optimal Capital Structure

The company’s goal is to find the best capital structure to:

1. Minimize WACC as much as possible
2. Maximize the market value of equity

Funding options:

• Using only owner’s equity (All Equity): Highest WACC, as shareholders bear all risks
• Using debt (Debt Financing): WACC decreases because the cost of debt is lower than equity, and tax benefits from deductible interest are gained

Cautions and Limitations of Using WACC

( 1. WACC does not account for future changes WACC is calculated based on current data and may not reflect future changes in interest rates, debt levels, or returns.

) 2. WACC does not include investment risk assessment Although WACC is a useful indicator, it does not consider project-specific risks. Relying solely on WACC for investment decisions may lead to inappropriate choices.

3. WACC calculation is complex

Determining WACC requires current data on capital structure, cost of debt, and cost of equity, which can be complicated to compute.

4. WACC is only an estimate

Accurate calculation of WACC is impossible due to many changing factors such as market interest rates and risk liquidity.

Effective Strategies for Using WACC

1. Use WACC alongside other indicators

Combine WACC with NPV ###Net Present Value### and IRR (Internal Rate of Return) for a more comprehensive evaluation.

( 2. Regularly update WACC calculations Update WACC calculations periodically to reflect changes in interest rates, debt levels, and economic conditions, enabling timely investment assessments.

Summary

WACC is a key financial metric for evaluating investment profitability. By understanding the cost of debt )cost of debt### and equity, along with the calculation formula, investors can make more informed investment decisions.

However, caution should be exercised when using WACC alone due to its limitations. It should be combined with other indicators and factors affecting financial costs. This approach allows investors to make the best and most suitable investment decisions aligned with their objectives.