Unlevered Return on EquityThe weighted average cost of capital (WACC) needs to be computed for a valuation. It represents the discount rate that used to present value cash flows when using the discounted cash flow valuation method.
When you think about cost of capital, think about what return an investor would expect to earn on your company based on its risk profile. This return has to be higher than the cost of capital for value to be created for the investors. Therefore, the cost of capital is the hurdle rate, or the minimum return expected.
WACC in UseThe cost of capital is "weighted" because it takes into account how much equity and debt is in your business, and how much each of these components cost on an after tax basis. However, the weighting for debt is based on a normalized capital structure rather than how much debt your specific business has.
The right WACC for any company is a moving target. One of the driving factors is the risk and return profile of each company. This is because cost of capital actually goes down the more debt a company has since debt is cheaper than equity. In addition, the interest you pay on debt is tax deductible. Hypothetically then, you should keep adding debt to continue reducing your cost of capital. However, this adds financial risk to your balance sheet because the company may not be able to pay the principal and interest related to this debt. Therefore, the right balance of debt and equity is required to balance out a low cost of capital with financial risk.
Typically, a company can use a lower cost of capital if it has lower perceived risk for investors. Defining risk is can also be a moving target. Risk can increase or decrease depending on the number of competitors, new technology, cyclicality in the industry the company operates in, cost increases in major inputs, and the list goes on. The size and stage of the company also factors in when assessing risk and WACC. The larger companies usually have a better ability to absorb shocks and therefore have a lower risk profile than a start-up. This means that in general terms, the larger and more diverse the company is, the lower the cost of capital will be since lower risk drives a lower return expectation for investors. Conversely, the smaller and riskier the company is, the higher the return expectation and therefore the higher the WACC should be. Think about a start up technology company that gets venture capital financing. For every technology company that succeeds, there are many others that don’t make it. Venture Capitalists know this and value these businesses expecting a high return to make up for this risk. This results in a lower valuations and a high return expectation, typically 40% - 50% as a minimum.
Computing WACCIn order to compute the WACC, you have to know two things:
- The unlevered return on equity, and
- The normalized capital structure for your business.
The simple formula for computing the weighted average cost of capital is as follows:
WACC = UE x (1 - T x D) where:
UE = the return on unlevered equity which essentially reflects the business risk that the Company is exposed to.
T = the specific, effective tax rate for the country and state the company resides in. Including tax is important because debt should be shown on an after tax basis since interest on debt is tax deductible.
D = the normalized debt to enterprise value of the company. This would reflect the normalized capital structure regardless of how much debt the company actually has.
Let’s relate the formula using some simple numbers.
Assume Company XYZ has an unlevered return on equity of 20% and operates in a jurisdiction where the effective tax rate is 30%. Also assume that the company the normal debt to enterprise value of the company is 50% in the industry. The WACC would be 17% for this company calculated as follows:
20% x (1 - 30% x 50%)
The cost of capital of a company reflects the level of normalized financial leverage or debt a business can put on. It tells you what an investor would use as a return on the particular business. Therefore, in the example above, 17% would be the discount rate used on a discounted cash flow valuation. Note that the discount rate does not include a growth factor. This is because it is assumed that the cash flows computed for the DCF have already incorporated a growth factor.