The “Weighted Average Cost of Capital” (WACC) refers to the cost to a company of obtaining financing both from investors in the form of equity, and from banking institutions in the form of debt or other banking instruments (e.g. bonds).
On the equity investors’ side, the cost of obtaining financing is determined either by the rate of return on investment that potential future shareholders wish to obtain, or for a particular market (CAPM method). The choice of methodology used to determine this cost often depends on the maturity of the company. The cost of debt, on the other hand, is simply the median interest rate obtained for all bank financing.
Once these rates have been determined with the financing players, it’s essential to establish the financing structure: what will be the proportion of equity and debt for the financing requirement determined?
Indeed, having more debt will generally reduce the WACC, while having more equity will tend to increase the WACC. However, it is essential to analyse the company’s ability to repay the debts it has contracted, in order to not find itself in an uncomfortable situation.
The WACC is used in the following two specific cases:
The WACC is used to obtain discounted cash flows at the date of the exercise. The value of future cash flows at the date of realisation is thus brought down to today. It is therefore very important to adjust the WACC as accurately as possible, as it plays a key role in the valuation of a company or project.
Two concepts are therefore very important in order to obtain a WACC as close to reality as possible:
Three methodologies are generally used to determine the cost of equity:
The cost of debt is much easier to determine, as it is the average or median of all the interest rates on the debts contracted. To be more precise, it’s better to use the median. Unlike the average, the median is not affected by the presence of extremely large or small values, which can distort the result.
Each company will therefore have its own way of determining the key factor in WACC: the cost of equity. The determination of this cost will often be torn between market data, the company’s wishes and the shareholders’ requirements for investment. The most important thing for a company is to be able to defend its choice as objectively as possible, and win the confidence of its investors.
The equity/debt split in the financing structure is also an important factor in WACC. It is therefore essential for the company to analyse all possible scenarios, while taking financial ratios into account, in order to find the best solution for financing itself.
Would you like more information on this topic? Please do not hesitate to contact Jean-Baptiste Duchesne.