The weighted average cost of capital (WACC) is simply an average cost of the two types of capital: debt and equity. It tells us the amount an investor would need in compensation to invest in a project. Therefore if we were to offer a lower return than the WACC, we would find that we have no investors; a return greater than WACC would lead to a situation where we have excess demand for our project.
To theoretically calculate the rate of return on a project we would need to compare it with existing returns on projects which have similar risk characteristics, and then set the return similar to these projects to ensure that we can attract finance.
WACC is often used by regulators in the pricing of controlled industries such as in the energy and telecom industries. These regulators calculate an allowed WACC which is intended to be high enough to encourage investment, but not so high that it allows excessive monopoly profits which these regulators are established to prevent. If the WACC is set too high then it could potentially lead to a situation of overinvestment (which may be considered good in the sense that it should lead to lower costs in the long run, but could be unsustainable) or super-normal profits at the expense of consumers; if set too low then we will have a situation of under-investment and potentially under-provision.
Obviously this assumes that regulators have sufficient information as to the variables involved in such calculations, that they don’t suffer from regulatory capture (the situation whereby the regulator is influenced too much by the supposed regulatees and ends up capitulating to the whims of such firms; in this case this could result in a higher WACC and higher prices for consumers). Finally we also have to assume that there aren’t political influences to the setting of WACC by regulators: for example they may base their decisions around final price increases, such that any price increase to consumers is politically feasible.
We can formally calculate the WACC as:
WACC = (Gearing * Cost of Debt) + ((1-Gearing)*Cost of Equity)
The cost of debt itself can be calculated as an average (or a weighted average) of existing debt and new debt. This makes sense; the cost of a given level of debt for a firm depends upon the interest rate it has to pay out on existing debt, and the interest rate it has to pay on new debt (either because the firm is expanding/investing or because it is rolling debt over).
The cost of equity can be calculated through a variety of methods, one such being through the Capital Asset Pricing Model (CAPM), not fully discussed here, which requires knowledge of things like the:
- risk-free rate – the interest rate which occurs given no risk, this is usually the rate on government debt, because a government can simply print money and should therefore not need to default on its debt
- equity premium – this is the difference between the return on bonds and on equity; it exists because bondholders are the first to receive a payment in the event of a firm going bankrupt, and therefore face less risk than equity holders who are the last to receive payment.
- asset beta – this indicates whether the investment is more or less volatile than other assets.
The costs above are assumed to be pre-tax for debt and post-tax for capital, if this is not the case then we would need further additional information of tax rates to adjust our results to get the above real vanilla WACC. In the capital asset pricing model, beta risk is the only kind of risk for which investors should receive an expected return higher than the risk-free rate of interest.
The level of gearing is the amount of debt a firm has in relation to its overall capital structure. So if we let capital = amount of debt + amount of equity then the level of gearing can be calculated as debt/capital.
It then makes sense that all our WACC equation is doing is adding up the cost of debt and the cost of equity which are both weighted by the amount of debt (gearing); we could do a similar exercise where we let gearing represent the amount of capital, and just adjust our formulae accordingly.