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💼 What is WACC?

Weighted Average Cost of Capital (WACC) represents the average rate a company must pay to finance its assets. It's the blended cost of all capital sources (debt and equity) weighted by their proportion in the company's capital structure.

Key Point: WACC is the minimum return a company must earn on its investments to satisfy all investors (both debt holders and shareholders). It's used as the discount rate for evaluating new projects and determining company value. If a project's return exceeds WACC, it creates shareholder value.

The WACC Formula

WACC = (E/V × Re) + (D/V × Rd × (1 - Tc))
Where:
E = Market value of equity
D = Market value of debt
V = E + D (total market value)
Re = Cost of equity
Rd = Cost of debt
Tc = Corporate tax rate

Simple Example

Company ABC Capital Structure:

Equity: $6 million (60% of capital)
Debt: $4 million (40% of capital)
Cost of equity (Re): 12%
Cost of debt (Rd): 6%
Tax rate: 28%
WACC = (0.60 × 12%) + (0.40 × 6% × (1 - 0.28))
WACC = 7.2% + 1.73%
WACC = 8.93%

Interpretation: Company must earn at least 8.93% on new investments to satisfy both shareholders and debt holders. Projects with returns below 8.93% destroy shareholder value.

Components of WACC

1. Cost of Equity (Re)

Return shareholders expect for their investment. Calculated using CAPM:

Re = Rf + β × (Rm - Rf)
Rf = Risk-free rate (government bonds)
β = Beta (stock volatility vs market)
Rm = Expected market return
(Rm - Rf) = Market risk premium

Example:

NZ government bond rate: 4.5%
Company beta: 1.2
Market return: 10%
Re = 4.5% + 1.2 × (10% - 4.5%)
Re = 4.5% + 6.6%
Re = 11.1%

2. Cost of Debt (Rd)

Interest rate company pays on borrowings. Use yield to maturity on existing bonds or interest rate on loans.

Total interest expense: $300,000
Total debt: $5,000,000
Rd = $300,000 / $5,000,000
Rd = 6.0%

3. Tax Shield

Debt provides tax benefit because interest is tax-deductible. This reduces the effective cost of debt.

Pre-tax cost of debt: 6.0%
Tax rate: 28%
After-tax cost = 6.0% × (1 - 0.28)
After-tax cost = 4.32%

Tax shield saves 1.68% (6.0% - 4.32%), making debt cheaper than equity.

Why WACC Matters

1. Project Evaluation (Hurdle Rate)

WACC is the minimum acceptable return for capital projects:

  • Project IRR > WACC → Accept (creates value)
  • Project IRR < WACC → Reject (destroys value)
  • Project IRR = WACC → Neutral (break-even)

2. Company Valuation

WACC is the discount rate in DCF (Discounted Cash Flow) valuation:

Company Value = Future Cash Flows / (1 + WACC)^n

3. Capital Structure Optimization

Companies adjust debt/equity mix to minimize WACC and maximize firm value.

4. Performance Measurement

Economic Value Added (EVA) uses WACC:

EVA = (Return on Capital - WACC) × Capital Invested

Typical WACC by Industry

Industry Typical WACC Characteristics
Utilities 5-7% Stable, low risk, high debt
Telecommunications 6-8% Regulated, predictable cash flows
Consumer staples 7-9% Stable demand, moderate risk
Manufacturing 8-10% Cyclical, capital intensive
Retail 8-11% Competitive, moderate risk
Technology 10-13% Growth, higher risk, low debt
Biotechnology 12-15% High risk, R&D intensive

Factors Affecting WACC

Market Conditions:

  • Rising interest rates → Higher WACC
  • Market volatility → Higher equity cost → Higher WACC
  • Economic recession → Risk premium increases → Higher WACC

Company-Specific:

  • Business risk (beta) → Higher risk → Higher WACC
  • Financial leverage → More debt initially lowers WACC, but too much increases risk
  • Credit rating → Better rating → Lower debt cost → Lower WACC
  • Size and stability → Larger, stable companies → Lower WACC
💡 WACC Sweet Spot

There's an optimal capital structure where WACC is minimized. Too little debt means missing tax benefits. Too much debt increases financial risk and raises both cost of debt and equity. Most companies target 30-50% debt ratio to balance benefits and risks.

⚠️ WACC Calculation Challenges

Market values vs book values: Use market values, not accounting book values
Estimating cost of equity: Beta and market premium are estimates, not certainties
Multiple debt instruments: Weight each by market value
Changing capital structure: WACC changes as debt/equity mix changes

🔢 Calculating WACC Step-by-Step

Example 1: NZ Manufacturing Company

Company XYZ Limited Capital Structure:

Step 1: Determine Market Values

Equity:
Shares outstanding: 10 million
Current share price: $8.50
Market value of equity (E): 10M × $8.50 = $85 million
Debt:
Bank loans: $30 million
Bonds outstanding: $20 million (at par)
Market value of debt (D): $50 million
Total value (V):
V = $85M + $50M = $135 million

Step 2: Calculate Weights

Weight of equity (E/V) = $85M / $135M = 63.0%
Weight of debt (D/V) = $50M / $135M = 37.0%

Step 3: Calculate Cost of Equity (CAPM)

Risk-free rate (NZ 10-year govt bonds): 4.2%
Market return (NZX50 expected): 9.5%
Company beta: 1.15
Re = Rf + β × (Rm - Rf)
Re = 4.2% + 1.15 × (9.5% - 4.2%)
Re = 4.2% + 6.10%
Re = 10.3%

Step 4: Calculate Cost of Debt

Total annual interest: $3.2 million
Total debt: $50 million
Rd = $3.2M / $50M
Rd = 6.4%

Step 5: Apply Tax Rate

Corporate tax rate: 28%
After-tax cost of debt = 6.4% × (1 - 0.28)
After-tax Rd = 4.61%

Step 6: Calculate WACC

WACC = (E/V × Re) + (D/V × Rd × (1 - Tc))
WACC = (0.630 × 10.3%) + (0.370 × 4.61%)
WACC = 6.49% + 1.71%
WACC = 8.20%
Decision Rule: Company XYZ should only accept projects with expected returns above 8.20%. A project returning 10% would create value (10% - 8.20% = 1.80% excess return). A project returning 7% would destroy value.

Example 2: Comparing Capital Structures

Company evaluates different debt levels:

Current Structure (30% Debt):

Component Value Weight Cost Weighted
Equity $70M 70% 11.0% 7.70%
Debt (after-tax) $30M 30% 4.32% 1.30%
WACC $100M 100% 9.00%

Proposed Structure (50% Debt):

Component Value Weight Cost Weighted
Equity $50M 50% 12.5% 6.25%
Debt (after-tax) $50M 50% 5.04% 2.52%
WACC $100M 100% 8.77%
Note: Higher debt increases both cost of debt (6% → 7%) and cost of equity (11% → 12.5%) due to increased financial risk
But tax shield benefit outweighs the risk increase
WACC decreases from 9.00% to 8.77%
Lower WACC = Higher company value

Example 3: Project Evaluation Using WACC

Company considers $5M factory expansion:

Project Cash Flows:

Year Cash Flow
0 ($5,000,000)
1 $800,000
2 $1,200,000
3 $1,500,000
4 $1,500,000
5 $1,500,000

NPV Calculation (Discount at WACC = 8.2%):

NPV = -$5.0M + $800K/1.082 + $1.2M/1.082² + ... + $1.5M/1.082⁵
NPV = -$5.0M + $739K + $1,025K + $1,190K + $1,100K + $1,016K
NPV = -$5.0M + $5.07M
NPV = $70,000 (Positive!)

IRR Calculation:

IRR = 8.5%
IRR (8.5%) > WACC (8.2%)
Decision: ACCEPT PROJECT

Project creates $70,000 of value and returns 8.5%, which exceeds the 8.2% cost of capital.

Example 4: Valuing a Company Using WACC

DCF Valuation of ABC Limited:

Projected Free Cash Flows:

Year FCF PV Factor (9% WACC) Present Value
1 $12.0M 0.917 $11.0M
2 $14.0M 0.842 $11.8M
3 $16.0M 0.772 $12.4M
4 $18.0M 0.708 $12.7M
5 $20.0M 0.650 $13.0M
Terminal $250.0M 0.650 $162.5M

Enterprise Value:

Sum of PVs = $11.0M + $11.8M + $12.4M + $12.7M + $13.0M + $162.5M
Enterprise Value = $223.4M
Less: Net Debt = $40M
Equity Value = $183.4M

If 10M shares outstanding, fair value = $18.34 per share.

🌍 Real-World WACC Examples

1
NZ Electricity Company

Utility company evaluating grid upgrade investment

Capital Structure (Actual NZ Power Company):

Market cap (equity): $2,400M
Debt outstanding: $1,600M
Total value: $4,000M
Equity weight: 60%
Debt weight: 40%

Cost Calculations:

Cost of Equity (CAPM):
Risk-free rate: 4.0%
Beta: 0.75 (utilities are stable, low beta)
Market premium: 5.5%
Re = 4.0% + 0.75 × 5.5% = 8.1%
Cost of Debt:
Average interest rate: 5.2%
After-tax (28%): 5.2% × 0.72 = 3.74%

WACC:

WACC = (0.60 × 8.1%) + (0.40 × 3.74%)
WACC = 4.86% + 1.50%
WACC = 6.36%

Project Decision:

Grid upgrade cost: $250M
Expected return: 7.5%
7.5% > 6.36% WACC
Approve project (creates value)
Why Low WACC: Utilities have low business risk (regulated, stable demand), high debt capacity (predictable cash flows), and low beta (defensive stock). This allows cheap financing and low WACC of 6.36%, making many infrastructure projects viable.
2
Tech Startup Valuation

High-growth SaaS company raising capital

Capital Structure:

Recent funding round valuation: $80M
Equity: $80M (investors + founders)
Debt: $5M (equipment financing)
Equity weight: 94.1%
Debt weight: 5.9%

Cost Calculations:

Cost of Equity:
Risk-free: 4.0%
Beta: 1.8 (high volatility, high growth)
Market premium: 6.0%
Re = 4.0% + 1.8 × 6.0% = 14.8%
Cost of Debt:
Interest rate: 9.5% (risky borrower)
After-tax: 9.5% × 0.72 = 6.84%

WACC:

WACC = (0.941 × 14.8%) + (0.059 × 6.84%)
WACC = 13.93% + 0.40%
WACC = 14.33%
💡 High WACC for Startups

Tech startups have high WACC (14%+) due to: high business risk, volatile earnings, high beta, limited debt capacity, and investor return expectations. They must generate high returns to justify investment. Most VCs expect 25-30%+ returns to compensate for risk.

3
Retail Chain Expansion

NZ retail company planning store rollout

Capital Structure:

Market cap: $350M
Bank debt: $120M
Bonds: $80M
Total debt: $200M
Equity weight: 63.6%
Debt weight: 36.4%

Costs:

Component Calculation Result
Cost of Equity 4.2% + 1.3 × 5.8% 11.74%
Cost of Debt 6.8% (blended rate) 6.80%
After-tax Debt 6.8% × 0.72 4.90%

WACC Calculation:

WACC = (0.636 × 11.74%) + (0.364 × 4.90%)
WACC = 7.47% + 1.78%
WACC = 9.25%

Expansion Analysis:

New Store Investment Expected Return vs WACC Decision
Auckland CBD 12.5% +3.25% ✓ Approve
Hamilton 10.2% +0.95% ✓ Approve
Invercargill 8.0% -1.25% ✗ Reject

Result: Open 2 stores (Auckland, Hamilton). Invercargill store would destroy value with 8.0% return below 9.25% WACC.

4
Capital Structure Optimization

Manufacturing company considers refinancing

Current Structure (25% Debt):

Item Amount Rate
Equity $150M (75%) 10.5%
Debt (after-tax) $50M (25%) 4.0%
Current WACC = (0.75 × 10.5%) + (0.25 × 4.0%)
= 8.88%

Proposed Structure (40% Debt):

Item Amount Rate
Equity $120M (60%) 11.2%
Debt (after-tax) $80M (40%) 4.5%
New WACC = (0.60 × 11.2%) + (0.40 × 4.5%)
= 8.52%

Impact:

WACC reduction: 8.88% → 8.52% (36 basis points)
On $200M enterprise value:
Annual savings: $200M × 0.36% = $720,000
Company value increase: ~$8-10M
Recommendation: Increase debt to 40% to lower WACC and increase firm value. Monitor financial flexibility and maintain investment-grade credit rating. Don't exceed 50% debt (risk becomes too high).

🎯 Test Your Knowledge

Complete this quiz on WACC

1. What does WACC represent?
The company's profit margin
The average cost of all capital sources weighted by proportion
The interest rate on debt
The return to shareholders only
2. Why is debt cost multiplied by (1 - Tax Rate) in WACC?
To punish companies for borrowing
Because interest is tax-deductible, reducing effective cost
To match accounting standards
It's a calculation error
3. Company has 60% equity (cost 12%), 40% debt (cost 6%, tax 28%). What is WACC?
9.0%
8.93%
10.2%
7.5%
4. WACC is used as the discount rate for:
Calculating taxes
DCF valuation and NPV project analysis
Determining dividend payments
Setting employee bonuses
5. A project with 10% IRR and company WACC of 8% should be:
Accepted (creates value)
Rejected (destroys value)
Neutral (no impact)
Needs more analysis
6. Which typically has the LOWEST WACC?
Tech startups
Biotech companies
Utility companies
Retail companies
7. Cost of equity is calculated using:
Dividend / Share Price
CAPM: Risk-free rate + Beta × Market Premium
Interest Rate + 2%
WACC - Cost of Debt
8. When calculating WACC, you should use:
Book values from balance sheet
Market values of debt and equity
Historical costs
Forecasted future values
9. Higher debt in capital structure generally:
Always increases WACC
Initially lowers WACC (tax benefit), but too much increases risk and WACC
Always decreases WACC
Has no effect on WACC
10. WACC is the minimum return a company must earn to:
Pay dividends
Avoid bankruptcy
Satisfy both debt holders and equity investors
Meet regulatory requirements

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