Understanding WACC and Cost of Debt in Investment Decisions

When considering investments in any project, many investors focus only on the expected returns. However, a deeper understanding requires considering the cost of debt, which is the expense of raising funds, including the Weighted Average Cost of Capital (WACC). WACC helps you evaluate the attractiveness of an investment more accurately. This article will introduce these concepts comprehensively, from definitions and calculations to effective application.

Cost of Debt: The expense of borrowing for a business

Cost of Debt refers to the expenses a company incurs when borrowing money from financial institutions such as banks, finance companies, or issuing bonds. This cost is usually expressed as an annual interest rate percentage. Understanding the cost of debt is a crucial starting point in analyzing whether borrowing is worthwhile.

For example, if a company borrows 100 million baht at an interest rate of 7% per year, the company’s cost of debt is 7%. However, it’s important to note that interest payments are tax-deductible expenses, which can reduce the effective cost below the nominal interest rate.

What does WACC include? - The company’s capital structure

WACC is the weighted average of all the company’s capital costs, consisting of two main components:

• Cost of Debt - Borrowing expenses

This is the interest paid to creditors. Since creditors have a higher priority for repayment than shareholders, their interest rates are typically lower than the expected returns of shareholders. Additionally, the interest expense is tax-deductible, providing a tax shield.

• Cost of Equity - Shareholders’ expected return

This represents the return shareholders expect from their investment. Shareholders face higher risk because they are paid after creditors, so they demand higher returns.

Calculating WACC and evaluating project attractiveness

When a company raises funds from both debt and equity, it must calculate the weighted average of these costs using the formula:

WACC = (D/V × Rd × (1 - Tc)) + (E/V × Re)

Where:

• D/V = proportion of debt in total capital
• Rd = cost of debt (interest rate)
• Tc = corporate tax rate
• E/V = proportion of equity in total capital
• Re = cost of equity (expected return)

Example calculation

Company XYZ has the following capital structure:

• Debt: 100 million baht (60%)
• Equity: 160 million baht (40%)
• Loan interest rate: 7% per year
• Corporate tax rate: 20%
• Expected return: 15%

Calculating WACC:

Step 1: Substitute values into the formula

D/V = 100/260 ≈ 0.3846
Rd = 7% = 0.07
Tc = 20% = 0.2
E/V = 160/260 ≈ 0.6154
Re = 15% = 0.15

Step 2: Calculate

WACC = (0.3846 × 0.07 × (1 - 0.2)) + (0.6154 × 0.15)
WACC = (0.3846 × 0.07 × 0.8) + (0.6154 × 0.15)
WACC = 0.0215 + 0.0923 ≈ 0.1138

Therefore, WACC is approximately 11.38%.

Comparing the expected return (15%) with WACC (11.38%) shows that 15% > 11.38%, indicating this project is worth investing in because the return exceeds the cost of capital.

Assessing the quality of WACC - When is it considered good?

A lower WACC is generally better, as it indicates the company has a cheaper cost of capital. However, whether a WACC is good depends on several factors:

Factors influencing WACC evaluation:

• Industry characteristics, as different sectors have varying typical WACC levels
• Risk level of the new investment project
• The company’s ability to generate cash flows
• Overall market conditions

Investment decision based on WACC:

• Expected return > WACC = worthwhile investment
• Expected return < WACC = not advisable
• Expected return = WACC = breakeven point

Optimal capital structure and reducing debt costs

The Optimal Capital Structure is the proportion of debt and equity that minimizes WACC and maximizes company value, aiming for two objectives:

1. Minimize WACC

Using an appropriate mix of debt can lower the average cost of capital because debt interest is usually cheaper than equity returns.

2. Increase market value of equity

Proper financing can boost the company’s stock price. However, excessive debt increases financial risk.

Adjusting debt proportions:

• All equity financing: Highest WACC but lowest risk
• Moderate debt: Reduces capital costs and benefits from tax shields
• Too much debt: Lowers WACC but raises financial risk

Cautions and techniques for effective WACC use

Limitations of WACC:

1. Ignores future changes

WACC is based on current data; interest rates, debt levels, and market conditions can change, making WACC an estimate rather than a precise figure.

2. Overlooks project-specific risk

Different projects have varying risk profiles, but WACC reflects the company’s overall risk, which may not be suitable for all investments.

3. Complex calculation

Requires current data on capital structure, costs, and taxes, which may be difficult to obtain accurately.

4. Only an estimate

Due to constant market fluctuations, WACC can deviate from actual costs.

Techniques for effective WACC application:

1. Use alongside other financial metrics

Combine WACC with NPV, IRR, and other indicators for comprehensive evaluation.

2. Regularly update WACC

Recalculate periodically to reflect changing market conditions and company circumstances.

3. Monitor market conditions

Track interest rate trends and borrowing costs to assess whether additional debt is cost-effective.

4. Analyze sensitivity

Study how changes in variables like interest rates or debt ratios impact WACC, understanding associated risks.

Summary

Understanding WACC and Cost of Debt is fundamental for making informed investment decisions. Cost of Debt represents the expense of borrowing and is a key component of WACC. By analyzing WACC, you can assess project viability, optimize capital structure, and plan to reduce funding costs.

However, investors should use WACC cautiously, considering its limitations and combining it with other financial tools. When applied appropriately alongside Cost of Debt and other factors, WACC enables you to select the best investment opportunities.