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Understanding Weighted Average Cost of Capital (WACC): Key Insights for Businesses

deminor NXT > News > Understanding Weighted Average Cost of Capital

Written by

Jean-Baptiste Duchesne

The Weighted Average Cost of Capital (WACC) is a critical metric for businesses seeking financing, whether through equity from investors or debt from banking institutions.

It reflects the cost to the company of obtaining these funds.

On the equity side, the cost is determined either by the rate of return investors expect or through market-based models such as the Capital Asset Pricing Model (CAPM). For debt, the cost is simply the median interest rate of all bank loans and other financing instruments the company holds.

WACC is fundamental in two specific contexts: discounted cash-flow (DCF) analysis and project return estimation. Accurate calculation of the WACC is crucial because it directly impacts the valuation of future cash flows and, consequently, the company’s or project’s overall value.

Equity Financing and its Impact on WACC

The cost of equity is one of the most challenging elements of WACC to determine.

There are three primary methodologies used to calculate it:

Market-based methodology (CAPM): This approach is used when market data is available and offers a benchmark for estimating returns.
Mature company comparison: For companies that are not yet mature, but for which comparable data is available from more established businesses, it can be beneficial to “borrow” these figures. This can serve as a reliable proxy for determining the cost of equity.
Early-stage assessment: For startups or early-stage companies without sufficient data or market comparisons, the cost of equity is often determined based on factors such as the risk associated with the product or service, team confidence, and overall company maturity.

“Ultimately, each company must justify its cost of equity to investors by defending it with market data, company-specific factors, or shareholder expectations.”

Debt Financing and WACC Reduction

Determining the cost of debt is a more straightforward process. Companies typically use the median interest rate from all their debt obligations, as it avoids distortion from unusually high or low rates that could skew the average. While debt often reduces WACC due to lower interest rates compared to equity returns, companies must carefully assess their ability to service debt to avoid financial strain.

A larger portion of debt in the company’s financing structure typically lowers the WACC, while a higher proportion of equity tends to increase it. However, a balance must be struck, as excessive debt could put the company in a precarious financial position.

The Role of WACC in Valuation and Decision-Making

The Weighted Average Cost of Capital is instrumental in discounted cash flow (DCF) analysis. DCF uses the WACC to bring future cash flows to their present value, making it essential to ensure WACC is as accurate as possible. Inaccuracies in WACC calculation can lead to over- or undervaluation of a company or project.

For investment analysis, WACC serves as the hurdle rate. If a project or investment opportunity has a return lower than the WACC, it would not be considered value-adding. Therefore, having a precise understanding of both the cost of equity and the cost of debt is crucial for sound financial decisions.

Conclusion

Each company will adopt its own approach to determining the key element of WACC: the cost of equity. This calculation is often the result of a delicate balance between market data, the company’s objectives, and shareholders’ expectations regarding returns. It is crucial for the company to justify its choice objectively and ensure that it gains the trust of its investors.

The allocation between equity and debt within the financing structure is also a determining factor in WACC. Therefore, the company must carefully assess the various possible scenarios, taking into account financial ratios, to find the most suitable financing solution.

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If you have any questions, please do not hesitate to contact us.

OCT 2023

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