Cost of equity
What shareholders require, usually estimated with CAPM: risk-free rate + beta x equity risk premium. The larger piece for most firms.
Definition
What is WACC (weighted average cost of capital)?
WACC - the weighted average cost of capital - is the blended rate a company pays to finance itself, combining the after-tax cost of its debt and the cost of its equity, each weighted by its share of total capital. It is the hurdle rate every investment must clear to create value, and the discount rate used to value future cash flows in a DCF.
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Short answer
WACC is the bar. A company that earns more than its WACC creates value; less, and it destroys value even while reporting a profit. That's exactly why ROIC is judged against WACC - and why WACC is the discount rate in a DCF.
What goes into WACC
Cost of debt (after tax)
The interest rate on borrowings, reduced for the tax deductibility of interest - which makes debt cheaper than equity.
Capital weights
The proportion of equity versus debt in the capital structure. More debt lowers WACC, up to the point risk rises.
Typical range: 7-10%
Where most large, stable companies land. Higher-beta, smaller, or riskier firms carry a higher WACC.
A worked example
A company funded 70 percent by equity (cost of equity 11 percent) and 30 percent by debt (after-tax cost 4 percent) has a WACC of 0.7 x 11% + 0.3 x 4% = 8.9 percent.
Now the test that matters: if that company's ROIC is 15 percent, it's creating value at a 6-point spread over its cost of capital. If its ROIC were only 7 percent - below the 8.9 percent WACC - it would be destroying shareholder value every year despite reporting positive net income.
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Related
- What is ROIC? - the return WACC is the hurdle for - the spread between them is what compounds.
- What is DCF valuation? - where WACC is used as the discount rate on future cash flows.
- What is intrinsic value? - the present-value figure WACC helps you calculate.
See returns judged against the right bar
invest-like benchmarks ROIC against the cost of capital inside the quality pillar of every verdict, so 'profitable' never gets confused with 'value-creating'.
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