The Weighted Average Cost of Capital! Also known as, WACC.
A discussion I had with a friend inspired me to write this post; we spoke about calculating the absolute minimum return a project would need to generate, in order for the project to be deemed feasible.
What is WACC?
WACC is a figure that a company would have to pay to providers of capital in exchange for borrowed capital; sources could be banks, investors, businesses etc.
You would typically use WACC when there is more than one source of capital; where there is only one source, you would not necessarily need to calculate an average, weighted, rate of return, as there would only be one figure/interest rate and that would serve as your WACC.
This WACC is a the return that you must generate as a bare minimum, to at least keep creditors happy and break even.
The assumption however is to generate a return that exceeds the WACC to create a profit for yourself too of course.
Why Would You Use WACC?
You would use WACC to calculate the absolute minimum return you must generate from your project; anything above this base figure is potential profit in your pocket.
The Weighted Average Cost of Capital calculation is also used to decide if whether it is feasible to progress with a project based on the cost of the project against the return on the project.
If for example, the profit, in percentage terms, does not exceed your cost of capital, then the project should be rejected – you wouldn’t be able to even generate an amount that will pay off the creditors! Therefore, do not progress with the project!
- You want to borrow money from a number of sources to buy a building and convert them in to single-let flats.
- You’re a business that wants to purchase another two retail units and in order to do so, will have to borrow money from the bank and two other investors
- You want to stock your furniture shop up and have borrowed capital from one bank and a family member.
Right, here’s how you calculate WACC. Let’s say for example you need £200,000 for a building that you want to buy to convert in to single-let flats. The £200,000 includes the purchase price and cost of works. You know four people that will fund your project, either through a joint venture, simple interest based borrowing, bridging loan etc. Let’s say you have four sources for capital and they are as follows:
Capital secured: £70,000
Interest rate/required rate of return: 8% per year
Source: Bridging Company
Capital secured: £75,000
Interest rate/required rate of return: 14% per year
Source: Hands-off Investor #1
Capital secured: £25,000
Interest rate/required rate of return: 7.5% per year
Source: Hands-off Investor #2
Capital secured: £30,000
Interest rate/required rate of return: 8.5% per year
Note: It is worth noting at this point that all sources have different required rates of returns/interest rates in exchange for the money they’re giving you for your project. The next question is, how do you calculate, in percentage terms, how much you need to generate from your project to pay them all back. I talk in percentage terms because often profits and rates (interest, WACC, tax etc) are presented in percentages (yield, return on investment, return on capital employed etc); this makes them directly comparable. Now the calculation you do is as follows:
The above calculation is based on the following:
WACC = Weighted Average Cost of Capital
Source Amount = The amount that has come from one particular source
Total Amount = The total figure gathered from all sources; £200,000 for this example
RoR = Interest OR Required Rate of Return
For the above project, 10.26% is the Weighted Average Cost of Capital and the minimum return you would need to generate from your project. Anything above this figure is money in your pocket. In the event, you know, based off other due diligence you have done, that you will get for example, a 23% return on investment for this project, you would deduct 10.26% from this 23%, leaving a tidy 12.74% potential profit for you.
You could incorporate tax in to this calculation by simply adding the tax rate that you expect to pay at the end, but I have intentionally left this out, as I know at this point, creative tax strategies are typically employed to offset or deal with tax more efficiently.
Last note; you may see people differentiate between the cost of equity (your money) and debt (somebody elses money). I haven’t got too complex with this calculation, however you would superficially be able to treat equity (your own money) as a form of debt. This is due to the fact that when you invest your own money, there is what’s called an opportunity cost by investing equity in the project because you could invest that money elsewhere to generate a return and as a result, a rate of return would be required – you could go a step further if a company is using it’s own money and calculate the value of shares + any loans taken by the company and use that as a cost of capital – talk to me for more detail. And lastly, as there is more risk with debt; often this is factored in to the rates of returns.
Last, last note; calculating the WACC can prove to be very useful and is the early stage of an investment/project appraisal, because all this calculation tells you is how much would be required to pay your creditors. The next step would be to calculate if whether the project would be cash-flow positive and this is where discounted cash-flow calculations come in, but we’ll talk about these later though.
Falling asleep now. Hope I haven’t made any spelling mistakes. Good nigt.