5.21 Weighted average cost of capital (WACC)
The weighted average cost of capital (WACC) provides a capitalization rate used in the capitalized cashflows valuation method to calculate enterprise value. WACC accounts for both the cost of equity and the cost of debt.
The cost of equity relates to the cost of capital provided by the owners of the business and represents the yield that an owner requires on his/her funds invested in the business. The required yield is in turn a reflection of the perceived risk in the business; as risks in the business rise, so will the required yield and cost of equity.
In building up to the capitalization rate, the cost of equity considers risk free rates, yields on publicly traded equities, industry risks, economic risks, and client specific risks, which can include a wide variety of factors that take account of the strengths, weaknesses, opportunities and threats faced by the business.
WACC is the weighted average of (a) the cost of equity and (b) the cost of debt, weighted in proportion to the amount of capital supplied to the business by (a) owners and (b) lenders.
The cost of debt is the after-tax cost of loan capital supplied by long-term lenders. Where there are several long-term loans with differing interest rates, further analysis is needed to determine the most suitable rate.
The cost of equity and the cost of debt, which are both expressed as percentages, are weighted according to the relative levels of capital supplied by owners and lenders.
For example, assume terms loans, with an average after-tax cost of 5% constitute 40% of total capital employed. Assume that the cost of equity has been determined as 15% (and note that shareholders’ funds constitute 60% of total capital employed). The capitalization rate used to calculate enterprise value will therefore be 11%.
WACC = (Shareholders funds x Cost of Equity) + (Total Capital x Avg After-Tax Cost)
(60% x 15%) + (40% x 5%) = 11%
Contact MVI to discuss how WACC in your business is determined and used to calculate the enterprise value.