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How can you use the weighted average cost of capital to make better capital budgeting decisions?

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Capital budgeting is the process of evaluating and selecting long-term investments that align with your business goals and maximize your value. One of the key inputs for capital budgeting decisions is the weighted average cost of capital (WACC), which represents the minimum return you need to earn on your projects to satisfy your investors and creditors. In this article, you will learn how to calculate and use the WACC to make better capital budgeting decisions.

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Charles Bayani

CEO & Founder of The Payment HQ | I help companies pay less (sometimes zero) in merchant card fees.

1 What is WACC?

WACC is the average rate of return that your company pays to finance its assets, taking into account both debt and equity sources. It reflects the risk and opportunity cost of investing in your company, as well as the capital structure and market conditions. To calculate the WACC, you need to multiply the cost of each type of capital by its proportion in the total capital, and then add them up. The formula is: WACC = (E/V) x Re + (D/V) x Rd x (1 - Tc) where E is the market value of equity, V is the total market value of capital, Re is the cost of equity, D is the market value of debt, Rd is the cost of debt, and Tc is the corporate tax rate.

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Charles Bayani

CEO & Founder of The Payment HQ | I help companies pay less (sometimes zero) in merchant card fees.
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WACC is easiest to understand when you imagine your company is like a pie made up of different ingredients: debt (money borrowed) and equity (money invested by shareholders). WACC is like the average cost of baking that pie, considering both the cost of borrowing money and the return expected by shareholders.

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2 How to estimate the cost of equity?

The cost of equity is the return that your shareholders expect to earn by investing in your company. It depends on the riskiness of your company and the market, as well as the preferences and expectations of your investors. One of the common methods to estimate the cost of equity is the capital asset pricing model (CAPM), which assumes that the cost of equity is equal to the risk-free rate plus a risk premium. The formula is: Re = Rf + β x (Rm - Rf) where Rf is the risk-free rate, β is the beta coefficient that measures the sensitivity of your company's returns to the market returns, and Rm is the market return.

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Charles Bayani

CEO & Founder of The Payment HQ | I help companies pay less (sometimes zero) in merchant card fees.
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Think of the cost of equity as the reward your company promises to give its shareholders for investing. Risk-Free Rate (Rf): This is like a guaranteed return you could get without taking any risk. It's a starting point for estimating the cost of equity. Beta (β): This measures how much your company's stock price moves compared to the overall market. Market Return (Rm): This is the average return of all investments in the market. So, the formula looks like this: Cost of Equity (Re) = Risk-Free Rate (Rf) + Beta (β) × (Market Return (Rm) - Risk-Free Rate (Rf)). This formula considers how risky your company is compared to the market and adjusts the expected return accordingly.

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Rosve Kuri Rodríguez

Profesor de Tiempo Parcial en UDLAP
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It is important to know that the cost of equity can also be calculated using the Gordon Method based on the dividends paid by a company, so you can use the formula ke = D1 / P0 + g, where ke is the cost of equity, D1 is the next dividend to be received, P0 is the price of the stock and g is the growth rate of those dividends

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3 How to estimate the cost of debt?

The cost of debt is the interest rate that your company pays to borrow money from lenders. It depends on the creditworthiness of your company, the maturity and features of the debt, and the prevailing interest rates in the market. One of the simple ways to estimate the cost of debt is to use the yield to maturity (YTM) of your existing or comparable debt instruments. The YTM is the annualized rate of return that you would earn if you hold the debt until it matures. You can use a financial calculator or an online tool to find the YTM based on the current price, coupon rate, and maturity of the debt.

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Charles Bayani

CEO & Founder of The Payment HQ | I help companies pay less (sometimes zero) in merchant card fees.
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Figuring out the cost of debt is like understanding how much your company has to pay back when it borrows money. Here's a super easy way to do it: Think about Interest Rates: This interest rate is what we call the cost of debt. Consider Your Company's ability to pay: Lenders want to know if your company is reliable and capable to pay back debt. Look at other loans similar to what your company might take out. How much interest are they charging? This can give you an idea of what your cost of debt might be. Use the Yield to Maturity (YTM): This is like a fancy term for the interest rate you'd earn if you held onto the debt until it was fully paid back. The cost of debt is the interest rate your company pays when it borrows money.

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4 How to adjust the WACC for risk?

The WACC that you calculate based on your current capital structure and market conditions may not be appropriate for all your projects, especially if they have different levels of risk. For example, if you are considering a project that is more risky than your average business, you may need to use a higher WACC to reflect the higher required return and discount rate. Conversely, if you are evaluating a project that is less risky than your average business, you may use a lower WACC to account for the lower required return and discount rate. One of the ways to adjust the WACC for risk is to use the pure play method, which involves finding a comparable company that operates only in the same industry or market as your project, and using its WACC as a proxy for your project's WACC.

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Charles Bayani

CEO & Founder of The Payment HQ | I help companies pay less (sometimes zero) in merchant card fees.
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Adjusting WACC for risk means taking into account how uncertain your company's investments are compared to others. If your company's investments are riskier, investors will want a higher return to compensate for that risk. Higher Risk, Higher WACC. If your company's investments are riskier than average, you may need to increase your WACC. Investor Perception Matters: If investors see your company as risky, they'll expect a higher return, leading to a higher WACC. While you want to adjust your WACC to reflect the riskiness of your investments, you also don't want it to be so high that it makes your projects unprofitable. Adjusting WACC for risk involves considering how uncertain your company's investments are.

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5 How to use the WACC for capital budgeting decisions?

The WACC is a useful tool for capital budgeting decisions because it helps you compare the profitability and viability of your projects. You can use the WACC as the discount rate to calculate the net present value (NPV) and the internal rate of return (IRR) of your projects, and then select the ones that have positive NPV and higher IRR than the WACC. Alternatively, you can use the WACC as the hurdle rate to calculate the profitability index (PI) of your projects, and then choose the ones that have PI greater than one. The WACC also helps you rank your projects based on their return on invested capital (ROIC), which is the ratio of the operating income after tax to the total capital invested. You can prioritize the projects that have ROIC higher than the WACC, as they create value for your company.

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6 What are the limitations of the WACC?

The WACC is a helpful measure of your company's cost of capital and required return, but it has certain limitations that you must take into account when using it for capital budgeting decisions. For instance, it assumes that your capital structure is constant and optimal, which may not be the case in reality. Additionally, the WACC relies on estimates and assumptions that may not be accurate or consistent, such as the cost of equity, the cost of debt, the beta coefficient, and the market return. Furthermore, it may not capture the specific risks and opportunities of your projects or reflect changing market conditions and expectations over time.

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Charles Bayani

CEO & Founder of The Payment HQ | I help companies pay less (sometimes zero) in merchant card fees.
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Here are 2 limitations of WACC 1. WACC assumes that the company's capital structure (the mix of debt and equity) remains constant over time. However, in reality, companies often change their capital structures by taking on more debt or issuing more shares. WACC doesn't account for these changes, which can lead to inaccuracies in the calculated value. 2. WACC is calculated based on the current market conditions and perceived risk. However, these factors can change over time. For example, if the economy becomes more uncertain or interest rates rise, the cost of debt and equity may change, affecting the WACC. WACC doesn't account for these fluctuations, making it less reliable for long-term investment decisions.

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7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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How can you use the weighted average cost of capital to make better capital budgeting decisions?

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1 What is WACC?

2 How to estimate the cost of equity?

3 How to estimate the cost of debt?

4 How to adjust the WACC for risk?

5 How to use the WACC for capital budgeting decisions?

6 What are the limitations of the WACC?

7 Here’s what else to consider

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