What is the average cost of capital? Get to know WACC in investment project evaluation.

Introduction: Why Understand WACC?

When considering investing in a company’s project, many investors often focus solely on the expected returns. However, an equally important factor is the true cost of capital, which must be compared against the investment’s potential returns. The metric that helps in this assessment is called WACC or Weighted Average Cost of Capital, which indicates how much a business needs to pay to raise funds to support its operations. This article will help you understand WACC deeply, from its meaning, calculation formulas, practical examples, to precautions.

What is WACC?

WACC stands for Weighted Average Cost of Capital, which translates to ต้นทุนเฉลี่ยถ่วงน้ำหนักของเงินทุน in Thai, or simply average cost of capital. It represents the average rate a company must pay to finance its operations.

A company sources its funds mainly from two sources: borrowing from financial institutions and raising equity from shareholders. Each source has a different cost. WACC is the weighted average of these two costs based on their proportions in the total capital. When evaluating the attractiveness of an investment project, managers and investors compare the expected return to WACC. If the expected return exceeds WACC, the project is considered worthwhile.

Structure of WACC: Two Main Sources of Funds

WACC comprises the costs of two types of capital, each playing a crucial role in the calculation:

Cost of Debt(

This is the expense the company incurs to borrow money from banks or financial institutions, expressed as an interest rate estimate. One advantage of debt is its tax deductibility—interest payments are tax-deductible expenses, which effectively reduces the real cost.

) Cost of Equity###

This is the return rate that owners or shareholders expect from their investment, which carries higher risk than debt because shareholders are last in line to be paid in case of liquidation. Therefore, the expected return is usually higher than the interest rate on debt.

WACC Calculation Formula

When a company raises funds from both sources, it needs to compute the average cost of all capital, called WACC, using the following formula:

WACC = (D/V)( R_d) * (1 - T_c) + (E/V)( R_e)

where:

This formula shows that WACC depends on the proportions of each funding source and their respective costs.

Practical Example of WACC Calculation

Consider the case of ABC Company, a listed company in the stock market. The management wants to calculate WACC to evaluate a new investment project.

ABC Company Data:

• Debt: 100 million THB (60% proportion)
• Equity: 160 million THB (40% proportion)
• Loan interest rate: 7% per year
• Corporate tax rate: 20%
• Expected return rate: 15%

Calculation:

Using the WACC formula:

WACC = D/V( R_d) * (1 - T_c) + E/V( R_e)

Plugging in the values:

• D/V = 100/260 ≈ 0.3846
• R_d = 0.07
• T_c = 0.2
• E/V = 160/260 ≈ 0.6154
• R_e = 0.15

WACC = 0.3846 * 0.07 * (1 - 0.2) + 0.6154 * 0.15

= 0.3846 * 0.07 * 0.8 + 0.6154 * 0.15

= 0.0215 + 0.0923

= 0.1138 or 11.38%

Analysis Result: Comparing the expected return (15%) with the WACC (11.38%), since 15% > 11.38%, the project is considered worthwhile to pursue, as the returns exceed the cost of capital, leaving a profit margin for shareholders.

How to Determine the Appropriate WACC Level

A lower WACC is always preferable because it indicates a lower cost of raising funds. However, the appropriate level of WACC depends on several factors:

• Industry of the company: Different industries have different typical WACC levels.
• Risk of the investment project: Higher-risk projects require higher WACC.
• Financial policy of the company: Strategic decisions on capital structure influence WACC.
• Overall economic conditions: Interest rates and market risks impact WACC.

Investment decision principles:

• If Expected Return > WACC → The project is worthwhile.
• If Expected Return < WACC → Do not invest.

Optimal Capital Structure: The Goal of Fundraising

Many companies aim to find the optimal mix of debt and equity to maximize benefits:

1. Minimize WACC (Minimize Weighted Average Cost of Capital)
2. Maximize market value of common stock (Maximize Market Value of Equity)

Funding options include:

( All Equity Financing ) Advantages: No risk of bankruptcy or tax issues. Disadvantages: WACC is highest because owners bear all risks.

( Mixed Debt and Equity Financing ) Advantages: WACC can be lowered since debt interest is typically lower than expected returns, and tax benefits are realized. Disadvantages: Must carefully consider debt risk.

Limitations and Precautions in Using WACC

Although WACC is a useful tool, it has several limitations:

( 1. WACC does not consider future changes

WACC is calculated based on current data, such as interest rates and debt levels. It cannot predict how these factors will change in the future. If interest rates rise or the company borrows more, WACC will change accordingly.

) 2. WACC does not account for project-specific risk

Different projects have different risk levels. Some may be riskier than the company’s normal operations. WACC does not reflect these differences, which can lead to misjudgments.

( 3. Calculating WACC is complex

Estimating the Cost of Equity using methods like CAPM )Capital Asset Pricing Model( requires extensive data, and estimates often have uncertainty. Continuous financial monitoring is necessary.

) 4. WACC is only an estimate

Many factors can change, such as interest rates, risk, and economic conditions. Therefore, WACC is not always precise. It serves as a reference indicator rather than an absolute measure.

How to Use WACC Effectively

To maximize the benefits of WACC, investors and managers should follow these principles:

( 1. Use WACC alongside other financial metrics

Do not rely solely on WACC. Combine it with other indicators such as:

• NPV )Net Present Value( — the net value today
• IRR )Internal Rate of Return( — internal rate of return
• ROI )Return on Investment( — investment return rate
• Payback Period — time to recover investment

Using multiple metrics provides a clearer overall picture of investment viability.

) 2. Regularly update WACC

Since factors change constantly, management and investors should update WACC at least two to four times a year. This ensures data reflects current conditions, helping track investment attractiveness. If WACC changes significantly, strategic adjustments or divestments may be necessary.

Summary: WACC as a Key Financial Indicator

Now you understand that WACC is a crucial financial metric, including its components, calculation methods, and practical applications. WACC is vital for managers, investors, and finance teams to evaluate investment profitability, business valuation, capital structure, and strategic financial decisions.

However, investors should use WACC cautiously, considering its limitations, updating data regularly, and combining it with other financial indicators to make reasonable and appropriate investment decisions.