WACC: What is it and how is it calculated?
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In today’s post we bring out our technical side to talk about another metric you should have under control if you are starting a business or thinking about it. One of the most important in corporate finance: WACC (Weighted Average Cost of Capital).
Its idea is quite intuitive: it tells you how much it costs to finance your company, and therefore, what is the minimum profitability you must generate.
What is WACC?
The WACC is the rate of return a company must achieve to cover the financing costs of its investments. In other words, it reflects the minimum return a company must generate to satisfy all its investors. As such, the WACC is a key indicator for making investment and financing decisions.
It’s not only about knowing how much you earn, but also about knowing if you earn enough to offset that cost. It works as a reference point: if an investment doesn’t exceed the WACC, it’s not generating value.
Now, why is calculating a company's WACC useful? The truth is that it is a very useful tool for making financial decisions, its uses are several:
- Evaluation of investment projects to know their viability and their capacity to generate value. Before launching new products, opening new business lines, or expanding into new markets, the expected profitability can be estimated and compared with the WACC.
- Negotiations with investors, as it can be taken as a reference to justify the minimum expected return.
- It helps to analyze the company's capital structure to optimize it and reduce costs.
- It serves to compare the return on investment with the cost of financing in order to make informed decisions.
How is WACC calculated?
The calculation of the WACC is based on a combination of funding sources. It involves weighting the cost of equity and the cost of debt, according to their proportion in the company's capital structure:
WACC=[(E/V)×Re]+[(D/V)×Rd]×(1−T)
Within this formula
- (E) is the value of the equity
- (D) is the value of the debt.
- (V) is the total value of the company (( E + D )).
- (Re) is the cost of equity.
- (Rd) is the cost of debt
- (T) is the tax rate.
To understand it better we can see it with a simple example. Imagine a company that has 5 million euros in equity (E) and 2 millions in debt (D). The cost of equity is 10% (Re), the cost of debt is 3% (Rd) and the tax rate is 30%. In this case the total value of the company would be 7 million euros. With this values we can now apply the formula:
[(5/7)×10%]+[(2/7)×3%]×(1−0,30)=7,74%
This final percentage means that any investment the company makes must generate a return greater than 7.74% to be truly worthwhile. If it doesn't reach this, it would generate less than the cost of financing it.
It’s important to know that the WACC isn’t a fixed value. It can change based on factors such as market conditions, business risk, or the company's financing structure. Therefore, it should be understood as a dynamic reference that helps to make informed decisions.
