Cost of capital is the money a business pays either in additional interest or by reducing its share in future profits in order to access the money it needs to evolve. Analysts and investors typically talk about the blended weighted average of a company’s cost of debt and cost of equity when discussing cost of capital.
This guide will help you understand the weighted average cost of capital (WACC) and how investors use it to calculate the value of your business. We’ll cover:
- What WACC means in business
- How to use the WACC formula to calculate cost of capital
- How investors use WACC to calculate cost of capital
- The limitations of the WACC formula
- Understand your business finances better with Countingup
What WACC means in business
Weighted average cost of capital (WACC) is something that analysts and investors use to assess their return on investment in a company. In other words, how much they’ll gain from the investment. Most businesses run on borrowed funds to some extent, so the cost of capital is a crucial part of assessing a company’s potential to be profitable.
WACC measures a company’s cost to borrow money, using both its debt and equity (worth) in its calculation to find the average cost of capital sources. In other words, WACC is the average rate a company expects to pay to finance its assets (valuable items).
Companies can raise working capital (money available to reinvest in the business) through various sources. For example, limited companies can raise money by listing company shares on the stock exchange (equity) or by taking business loans (debts). Raising capital this way comes at a cost, which varies depending on the source.
Let’s look at how investors and analysts calculate cost of capital using the WACC formula.
How to use the WACC formula to calculate cost of capital
While the WACC formula looks complicated to the untrained eye, and as a small business owner, you might never need to use it. It’s mostly used by investors and analysts and looks like this:
WACC = (E/V x Re) + ((D/V x Rd) x (1-T))
In this formula, the letters stand for:
E = Market value of the business’s equity
V = Total value of capital (equity + debt)
Re = Cost of equity
D = Market value of the business’s debt
Rd = Cost of debt
T = Tax rate
The WACC calculation has many parts and is impossible to figure out if you don’t know what the letters mean. But once you understand the components that make up the letters, it’s easier to understand.
Let’s look at the components:
Cost of equity
Calculating the cost of equity (Re) is one of the main areas you could slip up when using the WACC formula. This is because capital doesn’t have a set price since its value depends on how much investors are willing to pay.
If shareholders choose to sell their shares to your company, it decreases the company’s value. So the cost of equity is the amount your business must spend to maintain a good share price.
Cost of debt
Compared to the cost of equity, the cost of debt (Rd) is fairly simple to calculate. Here, you use the market interest rate (standard interest rate in the market) or the actual interest rate the company currently pays on its debt.
Interest is also tax-deductible, so investors need to account for the tax savings your company could take advantage of when making its interest payments.
How investors calculate cost of capital using the WACC formula
The WACC formula can be an effective way for investors to determine if your company is worth investing in.
Let’s say your company yields an average profit of 15% and has an average cost of 5% per year. This means the company essentially makes a 10% profit on every £1 it invests in itself. Investors see this as your company generating 10p of value for every £1 they invest, a value that can be distributed to shareholders as dividends (learn more here) or to pay off debt.
Now assume your company only makes a 10% profit at the end of the year but has an average cost of 15%. This means your company loses 5p on every £1 it invests since the costs are higher than the profits. Investors will likely shy away from a company like that, and you’d need to restructure your financing and decrease your overall costs.
The limitations of the WACC formula
There are some disadvantages that come with using the WACC formula to evaluate companies. The most significant downside is that it is much more complicated to learn how to calculate WACC than it might appear to. Some elements, like cost of equity, are not consistent, meaning different businesses may report them in varying ways.
As a result, the WACC formula isn’t great for comparing different results against each other. While the WACC formula can be a useful tool, it’s best to combine it with other methods to get a more accurate view of a company’s true investment potential.
You might never need to use the WACC formula for your business, but if you need to, it’s a good idea to consult a business analyst or accountant to help you understand how it works.
Understand your business finances better with Countingup
Projecting the cost of capital for potential investments in your business is a vital financial tool that can save you money. These calculations, along with maintaining financial records more broadly, can be useful but time-consuming tasks for new business owners. Use Countingup to save time and stress on your financial admin and understand your business’ capital better.
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