Average Cost of Capital: A Tool to Assess Investment Viability Every Investor Should Know

Investors often face the same problem: When analyzing a company’s new investment project, what should they compare the expected rate of return to in order to make the right decision? If you only look at the expected returns, it may lead to poor investment decisions because you forget that “capital raising” also has costs. This is why investors and financial analysts need to understand the WACC or Weighted Average Cost of Capital, which can be translated as the weighted average cost of capital.

Why is WACC important for investment decisions?

When a company wants to undertake a new investment project, the first thing to determine is the source of funding. This funding may come from bank loans or from shareholders. Similarly, when a bank agrees to lend money to a company, there is a cost involved (interest rate), and when shareholders agree to invest their money, there is also a cost (expected rate of return).

WACC is the calculation of the average cost of this capital. If the expected return from the investment project exceeds the company’s WACC, it indicates that the project is valuable and worth investing in. If it is lower, then the investment may not be worthwhile.

What components make up the average cost of capital?

WACC is a blend of two main sources of capital:

###Cost of Debt( This is the expense the company pays to borrow from banks or financial institutions, expressed as an interest rate. For example, if a company borrows 100 million baht at an interest rate of 7% per year, it must pay 7 million baht in interest annually.

)Cost of Equity### When shareholders invest money in the company, they expect returns in the form of dividends or capital gains. This is the cost from the shareholders’ side. The expected rate of return might be around 15% per year.

How to calculate WACC formula?

When a company has capital from only one source (either debt or equity), the calculation is straightforward. But when capital comes from both sources, the following formula is used to find the weighted average:

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

where:

• D/V = proportion of debt relative to total capital
• R_d = cost of debt or interest rate
• T_c = corporate income tax rate
• E/V = proportion of equity relative to total capital
• R_e = expected return on equity

The symbol (1 - T_c) accounts for the fact that interest expenses are tax-deductible, effectively reducing the actual cost of debt.

Practical application: real calculation example

Consider ABC Company listed on the stock exchange, with the following capital structure:

• Debt: 100 million baht (which is 60% of total capital)
• Equity: 160 million baht (which is 40% of total capital)
• Loan interest rate: 7% per year
• Corporate tax rate: 20%
• Expected return from shareholders: 15%

Plugging into the formula:

WACC = (100/260) × 0.07 × (1 - 0.20) + (160/260) × 0.15

WACC = 0.3846 × 0.07 × 0.80 + 0.6154 × 0.15

WACC = 0.0215 + 0.0923

WACC = 0.1138 or approximately 11.38%

In this case, if ABC’s new investment project has an expected return of 15%, since 15% > 11.38%, the project is considered worthwhile and worth investing in because the expected return exceeds the cost of capital.

How to interpret WACC correctly?

A lower WACC indicates that the company can raise funds at a lower cost, which is good news for investments. However, do not rely solely on WACC because other factors should be considered, such as:

• Industry characteristics: Different industries have different WACC levels. Companies in high-risk industries (like technology) tend to have higher WACC than those in stable industries (like utilities).

• Project risk: High-risk projects may require a higher rate of return than the WACC.

• Other metrics: WACC should be compared with NPV (Net Present Value) and IRR (Internal Rate of Return).

Designing the optimal capital structure

A company aims to find the best debt-to-equity ratio to achieve two goals:

1. Minimize WACC: to raise funds at the lowest possible cost.
2. Maximize market value of equity: to increase shareholder wealth.

However, excessive borrowing increases bankruptcy risk. Therefore, an optimal capital structure balances debt and equity to minimize WACC while managing risk.

Limitations of using WACC

( 1. WACC cannot predict the future

WACC is based on current data, but interest rates and risk levels can change. The company may need to restructure debt if interest rates change.

) 2. Does not account for project-specific risk

WACC is an average for the entire company, but individual projects have different risk profiles. High-risk projects may require a return higher than WACC.

3. Calculation complexity

Requires accurate, up-to-date data. Even a 1% error in estimating debt or equity costs can significantly alter WACC.

4. WACC is an estimate

Due to constantly changing factors, WACC cannot be precisely accurate. Investors should use it alongside other financial metrics.

Strategies to maximize the benefit of WACC

Regular updates are essential

As interest rates change or the company adjusts its debt levels, WACC will change. Regular updates ###such as quarterly### help monitor investment viability.

( Use WACC with other tools

Do not rely solely on WACC. Combine it with NPV, IRR, and other profitability indicators for a clearer picture of investment worthiness.

) Consider company context

Avoid comparing WACC across companies in different industries, as risk and capital structures vary.

Summary: WACC is an important but not sole decision-making tool

WACC or the average cost of capital is a key metric for evaluating investment profitability. It indicates how much a company must pay to raise funds. If the expected return exceeds WACC, the project is worthwhile.

However, WACC has limitations and should not be used alone. Investors should analyze comprehensively, considering risks, expected returns, industry environment, and other financial tools to make prudent investment decisions and achieve the best long-term returns.