What is WACC and how is it calculated?

Many investors consider WACC as the minimum rate of return that a company can generate for them.

What is WACC?

Weighted average cost of capital (WACC) is the rate at which the company raises its overall capital. The cost capital comprises the weighted average number of debt, equity and preference shares. In simple terms, WACC is the average rate at which the company finances its assets.

A company’s WACC depends upon its price volatility in the market and its credit spread or the rate at which the company borrows. WACC also depends on the general interest rate in the market. It can be considered as the minimum rate an investor anticipates while investing in a company as it captures all the sources of capital that has been used to finance the company’s assets. WACC is also used while preparing discounted cash flow valuation model for a company.

How do you calculate WACC?

WACC mainly comprises three components – equity, debt, and preference share. Its formula is given by:

Where,

K_e            :               cost of equity

W_e          :               weight of equity in the capital structure

K_d            :               cost of debt

t              :               tax rate

W_d          :               weight of debt in the capital structure

K_p            :               cost of preference share

W_p          :               weight of preference shares in the capital structure

Now, let us understand each of the components in brief –

Cost of equity: It is the minimum rate of returns that investor anticipates on the equity share. Compared to debt, it is difficult to calculate cost of equity as it does not have an explicit value. Cost of equity depends on the volatility of the stock in the market. Capital Asset Pricing Model (CAPM) is primarily used to calculate cost of equity which is given by:

Where,

R_f            :               risk free rate

R_m - R_f   :               equity risk premium

β             :               Volatility of stock wrt market

Cost of equity primarily depends on the volatility of the stock. To capture the volatility of the stock, it is important to it is calculate beta (β). Beta can be calculated by plotting the graph of percentage change  in historical stock prices of a stock wrt market. The slope of the plotted line is the beta of the stock. Higher the volatility of the stock, higher will be the beta.

Risk free rate can be considered as the rate at which government borrows. It can be taken as the current market rate on the 10-year Government Treasury Bond. Equity risk premium is calculated by subtracting 10 year Government bond rate from 5-10 year CAGR of the market.

Cost of Debt: Cost of debt is the interest rate that company pays on its long term borrowings. It is always calculated post tax as corporate tax is deductible in most of the countries. It can be calculated by dividing interest paid for a period by average outstanding debt over a period.

Cost of debt can be also calculated by adding credit spread of the company to the risk free rate.

Credit spread is based on the bond rating of the company. It is the rate over and above the risk free rate. Higher the credit rating, lower the credit spread. The following are the credit ratings on corporate bonds from highest to lowest:

AAA

AA

A

BBB

BB

B

C

D

Investors expect higher rate of return as the bond rating decline. As a result, credit spread increase when the bond rating decline. A company with higher bond rating will have lower spread hence will pay lower interest on its borrowed capital.

Cost of Preference share: Preference shareholders receive dividends on a fixed rate on its face value. This rate on the preference share can be considered as cost of preference share.

Practically, preference share does not hold much significance as most publicly traded companies do not issue preference share.

Let’s understand calculation of WACC with an example:

Reliance Industries has a current market capitalization of Rs 1,823,335.94 crore with total non-current liabilities of Rs 302,019 crore. So, the total capital employed will be addition of equity and debt (market cap and non-current liabilities) i.e. Rs 2,125,354.94 crore. Share of Reliance has a beta of 0.0477. In FY22, the company had interest expense of Rs 14,584 crore with average debt of 273,115.50.

Currently, yield on 10 year government bond is 7.30 per cent while BSE Sensex has delivered CAGR return of 13.10 per cent in the span of 5 years.

From the above information, we can conclude that, RIL has:

WACC calculation: