The weighted average cost of capital (WACC) is a cornerstone of any discounted cash flow valuation and a fundamental learning for every investor’s toolbox. This is because the WACC is used as the discount rate, or required rate of return, when doing a present value calculation of a company.
WACC can also be used by internal management of a company when evaluating the feasibility of new projects or continuation of existing ones taking into account the specific risk and capital structure of the project.
This article will discuss the logic behind WACC and provide various formula options for calculating the cost of different sources of capital. Readers will also be provided with the attached WACC calculator to use for their own investment purposes and walked through the use of the WACC calculator with an example of calculating the WACC of Walmart.
The Logic behind WACC as a Discount Rate
Before we jump into the calculations of WACC, let’s briefly touch on the logic behind its use as a discount rate.
Every company raises capital, be it equity, debt, or preferred equity, and invests that capital into assets. For a business or project to be economical with a positive net present value, the assets that the capital has been invested in need to be able to earn a return that is higher than the collective return owed on each source of capital. This comparison is referred to as the opportunity cost that could be earned on the capital elsewhere. If return on invested capital (ROIC) is lower than WACC, the business or project is not economical as an investment.
Side Note: Investors need to be sure to not mix apples and oranges which in this case means always using a discount rate that is appropriate for the ownership of the cash flow stream being present valued. As the WACC is a measure of the cost of ALL capital in a business, it is appropriate when the cash flow stream being present valued is before interest expenses and preferred dividends. On the other hand, if only cash flows to common equity are being present valued, then only the cost of equity portion of the WACC formula is appropriate for a discount rate as the cost of debt has already been accounted for by the subtraction of interest expense in the cash flow stream.
The WACC Formula
The WACC formula looks at the cost of each source of capital in percentage terms, including equity, debt, and preferred shares but could also include more exotic sources of capital such as convertible debt and warrants. The cost of each source of capital is then weighed by its use in the company’s capital structure. Below is the WACC formula in its entirety, we will then discuss calculation methodologies for the cost of each source of capital separately.
Cost of Equity
There are a few ways to calculate the cost of equity for a company such as the capital asset pricing model (CAPM) and a dividend discount model (DDM) approach. While both will be discussed here, for the purposes of the attached WACC calculator, we will focus on the Capital Asset Pricing Model (CAPM) method.
1. Capital Asset Pricing Model (CAPM): The CAPM estimates the cost of equity by starting with the risk-free rate of return demanded in the market on short-term 3-month U.S. Treasury bills. If the company is domiciled in another country, let’s say Germany, than that country’s short-term debt should be used as the risk-free rate, in that case German bunds. The CAPM then adds in the additional return required for taking on equity risk by multiplying the equity risk premium (which is the expected market return minus the risk-free rate) by the company’s beta on its shares in the public markets. While the expected market return can be calculated in its own right, for simplicity and consistency a rate of 10% can be used to represent the average return of the S&P since 1926. Beta is a particular calculation which can vary between sources so it is good practice to use an average of a few reputable sources for this input as we have done in the attached calculator.
Side Notes: While in reality there can be no true “risk-free” rate, financial theory uses government bonds as the approximated due to the low risk of default. That being said the U.S. did have their coveted S&P AAA credit rating downgraded a notch in 2011 to only AA. The maturity used for the risk-free rate can be a contested topic with most financial literature talking about short-term 3-month rates. However, a longer-term maturity consistent with the investment horizon can also be considered as it will more closely approximate the opportunity cost of investing in the “risk-free” bond instead of the equity investment.
2. Dividend Discount Model (DDM): This formula will look familiar to investors who have used a dividend discount model (DDM) to value a company. However, unlike a valuation where the investor in concerned with dollar figures, here we are looking at the formula in terms of percentages. To estimate the cost of equity using the DDM, first we divide the forward looking dividend by the current share price to get the forward dividend yield, and then, we add on a growth rate. Adding these two rates together, we are approximating the return that a shareholder would be expecting to earn on their capital.
Cost of Debt
The cost of debt can be calculated using a few methods such as the historic cost of debt as seen from the financial statements, the current weighted average yield-to-maturity (YTM) in the market of all a company’s debt, and also by using a build-up method which starts with the risk-free rates and then adds a credit risk spread. Ideally, the cost of debt should be calculated using current market rates and not the historic cost which debt was issued at. However, for us retail investors without a Bloomberg terminal at our desks to quickly tell us the YTM for each of a company’s outstanding bonds, we can make a rough approximation using historic figures from the face of the company’s financial statements. For this reason, the attached WACC calculator uses this historic method for the cost of debt.
Since interest is a tax deductible expense (at least for profitable companies), the cost of debt should be included in the WACC formula on an after-tax basis. This can be done by taking the before-tax cost of debt and multiplying it by 1 minus the tax rate. The tax rate can be found through looking at the historic average effective tax rate. That being said, the tax rate should be forward looking, so if tax rates have changed drastically such as with U.S. tax reform which lowered the corporate tax rate from 35% to 21%, the new forward looking tax rate should be used. Now let’s just into a few methods that can be used to estimate the cost of debt.
1. Historic Method: The historic method to calculate the cost of debt divides the interest expense found on the income statement by the average amount of interest bearing debt outstanding during the period which can be found on the balance sheet. It is important to note that interest bearing debt is not to be confused with total liabilities as seen on the balance sheet as not all liabilities are contributors of capital expecting to earn a return. This before-tax cost of debt is than multiplied by 1 minus the tax rate to yield the after-tax cost of debt.
Keep in mind that if interest rates have changed drastically in one direction or the company’s financial situation/risk profile has been altered since the company issued most of its debt, this historic approach based on each bonds coupon rate at issuance can come to a materially different cost of debt than the what the market YTM would be. For example, the current interest rate environment of 2020 has seen yields fall across the board for the past few years. If a company has not been proactively refinancing their historic debt at new lower market rates, their outstanding bonds will carry higher interest rates (which are the interest expenses flowing through the income statement) than the YTM these bonds are likely to be currently trading at in the market.
2. Market Yield-to-Maturity: To find a company’s cost of debt in current market conditions, we can look at the weighted average YTM on all of the company’s outstanding marketable bonds (as well as including credit facilities from the financial statements). This is arguably one of the most accurate methods to establish the cost of debt because it is market-based and forward looking by looking at the YTM instead of each bond’s historic coupon rate. As always with debt, this cost-of-debt is then looked at on an after-tax basis by multiplying by 1 minus the tax rate.
3. Build-up Method: Finding the cost of debt using the build-up method starts with selecting an appropriate risk-free rate and then adding onto it a credit spread to approximate the corporate risk of default. The risk-free rate selected should correspond with the length of the proposed investment in order for it to remain a valid indicator of opportunity cost of capital. This means that if one is looking at a 3-year investment, the 3-year government bond should be selected as the risk-free rate. The credit spread reflects the corporate default risk of the company and is associated with the company’s credit rating from large credit rating agencies (such as a Baa rating from Moody’s) and the average spread over the risk-free rate for similar rated companies. As always with debt, this cost-of-debt is then looked at on an after-tax basis by multiplying by 1 minus the tax rate.
Cost of Preferred
While not as prevalent as common equity or debt in the capital structure of a business, preferred equity is still a noteworthy part of the cost of capital discussion and always takes its place in textbooks. As can be seen below, the formula for calculating the cost of preferred equity is the same as the DDM for common equity but without the growth rate added because preferred shares do not participate in the growth of the business but are compensated by a higher dividend rate instead.
Example Calculation with Walmart
We will calculate the WACC of Walmart as an example to get readers comfortable using the attached WACC Calculator. The weighting and cost of capital is calculated on the first tab entitled WACC Summary with the cost of equity calculated in the second tab using the CAPM method and the after-tax cost of debt calculated in the third tab using the historic method. There are no preferred shares with Walmart but this has been included in a fourth tab of the calculator in case investors ever run across a company with some preferred equity outstanding. In each tab the red highlighted cells can be updated with data from sources for the company being analyzed. The sources and links provided for Walmart can be used as an example for where to look when plugging in data for a new company being analyzed. Now let’s get into the details with Walmart.
Cost of Equity – CAPM
- Risk-Free Rate: As a U.S. domiciled company, the risk-free rate used has been the short-term 3-month rate (13-week) as found from the U.S. Department of the Treasury website seen below.
Sourced from U.S. Department of the Treasury website
- Beta: As a consumer staple company, Walmart would be expected to have market risk and a beta of lower than 1. As mentioned earlier, it is best to use the average of a few sources for beta as calculation methods can vary. For the 3 sources used as a beta for Walmart, beta ranged from 0.35 to 0.62 for an average beta of 0.45. Below is a screen shot from one of the sources.
Sourced from Yahoo Finance
- Expected Market Return: The expected market return used has been the previously mentioned 10% which is widely quoted as the historical return for U.S. markets since 1926.
- Market Capitalization: In order to find the weighted average (which takes place on the first summary page) each source of capital needs to be weighted by its use in the capital structure. For equity, this means that we have to multiply the cost of equity by Walmart’s market capitalization divided by the total capital in the business. The market capitalization can be found from numerous financial websites such as Yahoo Finance as seen below.
Sourced from Yahoo Finance
Cost of Debt – Historic
- Interest Expense: To build the cost of debt using the historic approach we need to look at Walmart’s latest annual financial report which can be found from a company’s Investor Relations website. Looking at the income statement, we see that Walmart had $1,975M of interest expense during 2019. Also note that for a retailer with lease obligations, these will also now be shown on the financial statements since IFRS 16 and ASC 842 accounting standards came into use and made it mandatory for business to capitalize and expense almost all lease obligations. However, as these lease obligations do not represent actual capital which a company has received and the money that would be needed to start a similar business, they should be excluded from our cost of debt calculation.
Sourced from Walmart’s 2019 Annual Report
- Beginning and Ending Debt: To transform the interest expense into a percentage form, we need to divide it by the average amount debt outstanding over the year. Looking at the balance sheet of Walmart below, we want to take the average of all the interest bearing debt outstanding over the two periods.
Sourced from Walmart’s 2019 Annual Report
- Debt Outstanding: In order to find the weighted average which takes place on the first summary page, each source of capital needs to be weighted by its use in the capital structure. For debt using the historic approach, this means that we have to multiply the cost of debt by Walmart’s debt outstanding at the latest reporting period divided by the total capital in the business.
Weighing It All Together
Now that both the cost of equity and debt have been calculated, we can put them together in a weighted average. As can be seen below, the market capitalization and total debt outstanding form the numerator in each respective capital weighting and the sum of them together forms the denominator. As Walmart is a trusted consumer staple company, its WACC would reasonably be expected to be on the low side of things and, as calculated at 5.05%, that expectation would appear correct.
To read more about how the WACC calculation can be used for in a Discounted Cash Flow Valuation, click on this link.