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In the valuation of a business, a term that often comes up is the weighted average cost of capital (or WACC). WACC is simply a company’s cost of capital and reflects a rate of return that a company expects to pay, on average, to its security holders to finance its assets. As a company’s cost of capital, all sources of capital are considered. This will include sources from equity (e.g. common stock and preferred stock) and debt.
WACC is determined by the external market and not by the company’s management as it represents the rate of return a company must achieve using its existing asset base to satisfy its sources of capital (e.g. creditors, owners and other potential providers). If a company cannot achieve this rate of return, market theory dictates that these investors would invest their capital elsewhere.
Based on this, WACC can be considered as a reflection of a company’s “risk” profile as viewed by the market – the riskier a company is, the higher required rate of return a capital investor will require and ultimately, the higher the WACC will be for the company.
Valuators have available to them several methodologies in determining the WACC for a company. As the WACC reflects the cost of capital both from equity and from debt sources, the determination of an appropriate WACC for the company must weigh in the required returns on interest-bearing debt and equity capital in proportion to their estimated relative percentages in an expected optimal capital structure.
The determination of the required return on debt is relatively easier than the determination of the required return on equity. This is mainly due to the fact that most companies have some form of debt already. Further, there are general rules of thumb that estimate the level of debt that a company can finance, either through an asset backed financing, or cash flow financing structure. Many sites also have available the level of interest a market lender would charge on a company that is at a certain risk level. With regards to the return on equity component, two common methods are used to determine the required return on equity, the build-up method and the capital asset pricing model (CAPM).
Stay tuned for next week where we explore the build-up method in the determination of a company’s required return on equity and the overall determination of the WACC.