Cost of Capital – Is Your WACC Out Of Whack?
16 November 2006
Determining a company’s overall cost of capital can be as much an art as it is a science. Debt instruments for the most part are straightforward, but the cost of equity can vary widely depending on a number of variables including industry sector, private / public status, and the degree to which the business is leveraged.
Cost of Debt
The pre-tax cost of debt a Company faces is simply the coupon or interest rate on the face of the debt. Debt does however have a benefit over equity in that interest payments are tax deductible. As a result, the after-tax cost of debt is generally lower than the face value cost of debt (assuming of course the business is in a position where it must pay taxes). The after-tax cost of debt is determined by this formula:
- After-Tax Cost of Debt = (1 – % Tax Rate) x Pre-Tax Cost of Debt
The interest rate on debt is determined by the debt rating assigned to a Company. For smaller public and private firms, this can be synthetically determined based on the Company’s interest coverage ratio. Each debt rating has a spread over long term government bonds (the risk-free rate) associated with it. As would be expected, the riskier the debt rating (i.e. lower interest coverage ratio), the greater this spread will be. The spread can be as low as 0.5% for AAA ratings, and can exceed 15% for the lowest high-yield (junk-bond) ratings. If warrant issuance is involved, this would slightly increase the notional cost of the debt capital in question.
Cost of Equity
This is the expected return a Company’s shareholders will want a business to generate for them. A popular method of calculating this is the Capital Asset Pricing Model (“CAPM”). There are 3 components to the calculation – the risk-free rate (what an investor could receive from a government t-bill / bond), the unlevered beta of the equity instrument and finally a market risk premium.
The risk-free rate as with debt, is based off of a government security such as a long term bond or short term t-bill. It is generally a return just slightly higher than inflation. Recently, the risk-free rate has been around 4% in Canada.
The beta of an equity is a measure of the risk involved in investing in a particular stock. By definition, the market as a whole has a beta of 1.0. The individual beta for a Company compares that company’s risk to the general market. Thus, if an equity beta is 2, that stock will be twice as risky / volatile as the general market. A beta of less than 1 will be less volatile (i.e. most utilities). Finally, a negative beta will move in the opposite direction of the market (often gold stocks are a prime candidate). Beta is also affected by the level of debt in a business – the more debt, the riskier the equity will inherently be (and thus a higher beta). To make betas comparable between companies, the beta must be unlevered:
- BetaUnlevered = BetaLevered / (1 + (1 – Tax Rate) x (Debt / Equity))
Finally, the market risk premium is the difference between the risk free rate and the return a typical investor would expect to achieve in a particular market. If the expected return was 10% and the risk-free rate was 4%, the market risk premium would be 6%; Ibbotson data suggests that the average CDN equity risk premium is approx 5.5% dating back to 1947. Simply put, this is the additional return an investor requires in order to consider placing their capital in an equity instrument rather than a more secure bond. In recent years, this value has tended to be 4-5% in Canada for blue-chip, dividend paying businesses in the public markets. Then there’s something called the “small cap premium” or “business risk premium” that some analysts add, which can range for 50 bps to 300 bps or more.
In the private / venture equity world, the market risk premium can be considerably higher than the public markets due to a greater perceived risk. It is not unusual for investors across the continent to demand a total cost of equity of 35-40% plus.
Placing these elements together, we arrive at the CAPM formula:
- Cost of Equity = Risk-Free Rate + (BetaUnlevered x Market Risk Premium)
Cost of Capital
To determine the weighted average cost of capital (“WACC”), simply take the percentage of the balance sheet financed by debt and multiply by the cost of debt (after tax), then add the percentage of the balance sheet financed by equity multiplied by the cost of equity. The resulting value can be used to determine the economic viability of new projects, acquisitions, etc. Essentially, any future action taken should result in a return that is greater than the WACC, otherwise the opportunity should be passed upon as it would destroy value.
- WACC = (% Debt x After-Tax Cost of Debt) + (% Equity x Cost of Equity)
We invite you to try our Cost of Capital Calculator tool located on the left sidebar of the blog. By inputting a few variables about your company, it will provide a quick approximation as to what your current cost of capital is, as well as suggest an optimal level of debt in your business to minimize this value.
Jason
2 Responses to “Cost of Capital – Is Your WACC Out Of Whack?”
August 31st, 2008 at 5:48 pm
Dear Jason,
Nice post. Thanks for sharing. It gave me a full picture about WACC.
My friend came accross trying to use WACC in a low risk, with return project. He said WACC not suitable. But don’t know why. Do you have some idea?
I found cost of debt always lower than cost of equity. Is this a fixed rules? Why?
Mind to share your thought? Hope you can give some opinion. Thanks
September 2nd, 2008 at 3:05 pm
Brandon,
Thanks for the comment.
I’m not sure about the specifics of your friend’s investment opportunity, so it’s difficult to comment on the suitability of WACC in that case.
As a general rule of thumb, the WACC of a low risk project would be lower than that of a high risk project. This relies on a perfectly efficient marketplace in which every participant has access to all available information. Anomalies may exist where an opportunity would be low risk but high return for an investor. If many people find out about this though, more people will want to participate and drive the price of that investment up (and correspondingly, the return down), restoring general order to the market and eliminating the anomaly. From the Company’s perspective, a more costly investment for the investor means a lower cost for the Company (i.e. fewer debt covenants or more equity $$ in for the same number of shares out). So the general rule holds… low risk = low return.
As for debt being lower cost than equity, all other things being equal this will generally hold true. Debt has an advantage over equity in that debt holders will rank ahead of equity holders should a company enter bankruptcy, have to liquidate itself, etc. There is a much better chance they will recover most if not all of their investment before equity holders would receive any payout. As a result of this advantage, the return will generally be lower for debt (remember, low risk = low return in an efficent market).
Keep in mind this may not hold true across two different opportunities though. It is possible that the cost of equity in a well established blue-chip company could be lower than the cost of debt in a risky start-up with no history for example.