Understanding WACC: A Key Tool for Investment Decision-Making

When Should You Know Your WACC?

In the world of investing, many investors often face tough questions: Is a company’s interesting project truly worth investing in? Some only look at potential returns, but is that enough to make a conclusion? No, because investment decisions must also consider the cost of capital used. This is where WACC comes in, helping us measure how much it costs to raise funds.

What is WACC? And Why Is It Important?

WACC stands for Weighted Average Cost of Capital, which refers to the average weighted cost of capital that a company must pay to obtain funds for operations. In other words, it is the minimum rate of return a company needs to generate to cover its cost of raising capital.

Why is it important? Because WACC helps answer a key question: if an investment project yields a return higher than WACC, then it is worth investing in. If lower, then it is not.

Components That Make Up WACC

The WACC consists of two main components of capital cost:

1. Cost of Debt (Cost of Debt)

This is the interest rate the company must pay when borrowing from banks or financial institutions. For example, if borrowing at an interest rate of 7% per year, that is the company’s cost of debt.

2. Cost of Equity (Cost of Equity)

This is the return rate that shareholders expect, compensating for the risk they bear. This rate is usually higher than the natural interest rate because stocks carry more risk than debt.

The WACC Calculation Formula You Need to Know

If a company uses only one source of capital, the calculation is simple. But most companies use both debt and equity, so a weighted formula is necessary:

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)
• Tc = corporate tax rate
• E/V = proportion of equity relative to total capital
• Re = cost of equity (expected return rate)

Real-World WACC Example

Let’s look at an example with ABC Company listed on the stock exchange:

ABC Company Data:

• 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 for shareholders: 15%

Calculation:

WACC = (100/260) × 0.07 × (1-0.2) + (160/260) × 0.15

WACC = 0.3846 × 0.07 × 0.8 + 0.6154 × 0.15

WACC = 0.02154 + 0.09231

WACC ≈ 11.38%

Meaning of the result: ABC Company needs to generate a minimum return of 11.38% to cover all capital costs. If a project yields 15%, it is considered good because it exceeds WACC.

What Should a Good WACC Be?

A lower WACC is better because it indicates the company has a lower cost of raising funds. However, “good” depends on the context:

• If expected return > WACC: the project is worthwhile
• If expected return < WACC: the project is not worthwhile

Other factors such as industry type, risk, and economic conditions should also be considered.

Optimal Capital Structure

Companies can reduce WACC by adjusting their capital structure:

Using only owner’s equity: WACC will be high because shareholders accept higher risk.

Mixing debt and equity: WACC decreases because debt costs are lower, and there are tax benefits from deductible interest.

Excessive debt: WACC may increase due to higher financial risk.

Cautions to Keep in Mind

1. WACC does not predict the future – It is calculated based on current or historical data and cannot forecast future interest rate or risk changes.

2. WACC does not account for project-specific risk – Different projects have different risk levels; WACC is an average for the entire company.

3. Calculation complexity – It requires current data and sometimes subjective estimates.

4. WACC is an approximation – Factors change over time, making this value not always precise.

How to Use WACC Effectively

1. Combine with other metrics – Use WACC alongside Net Present Value (NPV) and Internal Rate of Return (IRR) for comprehensive analysis.

2. Update regularly – Review WACC periodically, especially when interest rates or capital structure change.

3. Consider industry context – Compare WACC with competitors in the same industry, as different sectors have different typical WACC levels.

Summary

WACC is the weighted average cost of capital, an essential tool for evaluating investment profitability. Its calculation considers both debt and equity costs, and a lower WACC is generally better.

However, investors should use WACC carefully, in conjunction with other analyses, to make informed investment decisions. Always remember that this is just one part of the broader financial analysis picture.