With this piece, we take a look at What is WACC in Finance, the topic is a must-know for a Finance student. Given that is the case, we’ve taken a look at everything you need to know via this piece.
“There is no free lunch”, a saying in Economics goes and businesses are no exception to it. Businesses need capital for functioning which they raise from shareholders or by borrowing. This capital comes at its own cost, investors and lenders seek something in return for the risk they take by providing their capital to a business. Now, let’s understand what these costs are.
What is WACC
Breaking down the WACC
Cost of Debt (Kd)
Whenever a company borrows from lenders or creditors, it is expected to pay timely interest on the borrowed amount along with the principal amount. The payment of this interest incurs a cost for the company and it is known as cost of debt. But it is intriguing to note that the interest paid is not equal to the net cost of debt. Here’s why…
Let’s assume that a company ABC Ltd has borrowed $100,000 at 12% interest rate and the corporate tax rate is 30%. Now, remember that interest is tax deductible, which simply means that the entire 12% is not exactly what the company pays. Let’s understand in a simpler way.
If interest were not tax deductible, the company’s cost of debt would have been 12% of the borrowed sum, which amounts to $12,000. But since it is tax deductible, the net cost incurred by the business will be equal to (1-tax rate)*interest rate.
Net Cost of Debt (Kd)= (1 – Tax Rate)*Interest Rate
= (1 – 0.3)*12
= 8.4 %
We can see that the net cost of debt is $8,400 or 8.4% of the borrowed amount, which is lower than the interest rate.
Now, coming back…..
The cost of debt remains fixed over the tenure of a loan. However, not all businesses have the same cost of debt. It is a function of risk in the business. The higher the risk, the higher is the return that the lenders seek. Therefore, risky businesses tend to have a higher a cost of debt. In India, the average cost of debt ranges from 12-14%.
Cost of Equity (Ke)
Just as lenders expect returns, equity investors also expect returns from a business. In fact, equity investors seek higher returns than what lenders expect, simply because they take a higher risk. It is so because if a company goes bankrupt and all its assets are resolved, then the amount obtained from such a resolution process is used to pay the lenders first. After all the debt has been paid off, the remaining amount goes to equity shareholders.
Now, let’s understand how the cost of equity is calculated.
The Capital Asset Pricing Model (CAPM) is used to arrive at the return an investor would seek on invested equity capital. The calculation of expected rate of return is a bit complex, but don’t worry, we are here for you. Its formula has been given below.
Expected Rate of Return = Risk-free Rate + β*(Market Rate of Return – Risk-free Rate)
Symbolically, it can be written as:
Rr = Rf + β*(Rm – Rf)
Now, let’s understand each term in detail.
Risk-free Rate (Rf)
Ideally, no investment instrument has zero risk involved but for practical purposes bonds issued by central government of a country are considered risk free, as the probability of a government going bankrupt is low. In the Indian context, the risk free rate is considered equal to the yield on a 10-year government bond. Generally, it is taken to be around 6% on an average.
A stock market has systematic risks which cannot be reduced. These risks can be attributed to the uncertainty in macroeconomic indicators such as GDP, inflation, currency exchange rates, oil prices etc, to which the market is bound to react. Whereas, an individual stock of a company has its own risks called unsystematic risks, that are linked to the financial position of the company and the nature of its industry (Note that the mentioned risks are probabilities of a stock or an index losing value). So, beta basically relates the unsystematic risk of a company’s stock to the systematic risk of the stock market. Statistically, risk can be measured as the rate of return (Remember the principle, “Higher the risk, higher the return”?). So, beta is nothing but the comparison of rate of return a stock and that of the broader market.
Mathematically, it is given as:
β = (Covariance (Stock return rate, Market return rate))/ (Variance (Market return rate))
To understand it better, let’s assume that the beta is 0.83 for the stock of ABC Ltd. This implies that if the stock market goes up by 100 points, the stock price will go up by ₹ 83 and vice-versa. We can conclude from this that the stock is less volatile as compared to the market and the risk of it losing its value is lower in comparison to the market. Similarly, a stock having beta greater than 1 is more volatile as compared to the market.
Market Risk Premium (Rm -Rf)
Market risk premium is the additional return that an investor expects over and above the risk-free return rate for the risk he/she takes by investing in the stock market. It can be calculated using historic data of year-on-year returns given by a broad index in the stock market, such as the BSE-100. The table below shows the data of 10-year rolling return of BSE Sensex from 2011 to 2018. An average of has of these returns has been taken to arrive at the market rate of return, which is between 12-13%.
We’ll get the market risk premium as 6-7% after subtracting the risk-free rate from the market rate of return.
Now that we know the prerequisites for calculating the Cost of Equity, we will proceed with the calculation.
Here’s what we know:
Rf = 6%
Rm – Rf = 7%
And, we will assume, β = 1.23
Rr = 6% + 1.23*7%
Rr = 14.61%
The expected rate of return is equal to the Cost of Equity (Ke). Therefore, Ke will be 14.61%
Now, we can move ahead to understand WACC.
Weighted Average Cost of Capital (WACC)
Generally, a company’s capital structure comprises of both equity capital and debt. That is the reason why WACC needs to be calculated. It is the cost that the company is expected to pay to its shareholders and lenders. It is calculated by taking the weighted average of cost of debt and cost of equity in proportion to their share in the capital structure.
Mathematically, it can be written as,
WACC = (Weight of Equity * Cost of Equity) + (Weight of Debt * Cost of Debt)
WACC = we * Ke + wd * Kd
Let’s say that the company has 30% of its capital as debt and the remaining 70% as equity, then the weight of debt will be 0.3 and that of equity will be 0.7.
WACC = 0.7*14.61 + 0.3*8.4
WACC = 12.75%
The higher the debt component in the capital structure, the lower will be the WACC of the company and vice-versa but we very well know that high debt increases the risk of insolvency of a business. For businesses, it is important to generate returns from the business that are higher than its WACC to sustain the business in the long run. Only if generates more than what it is paying, will it be able to grow and create value for its shareholders