The weighted average cost of capital (WACC) is the cost of capital a company expects to pay to all its stakeholders including equity and debt-holders. First we calculate the marginal cost of capital for each source of capital such as equity and debt, and then take the weighted average of these costs.
While calculating the WACC is a straight-forward calculation, and even getting the values of equity and debt is easy, there are some practical problems in calculating the cost of equity and cost of debt. Let’s discuss these problems.
- While estimating the cost of equity, one can use different methods such as the dividend discount model, the CAPM model, or even bond yield plus risk premium. In each model, the inherent problem is that atleast one of the variables is an estimate. For example, in the Gordon growth model, we are making an assumption about the growth rate. In CAPM, we are making assumption about the market risk premium using historical data. Even the value of Beta is difficult to ascertain if the company’s stock is not traded. Due to variation in the estimates, our cost of capital will also vary.
- To estimate the cost of debt, we take the risk-free rate and then add a risk premium to it. There is problem with both. We need to take a higher risk premium as the amount of debt increases. Also, risk-free rate should be derived from bonds that have a maturity equal to the duration of the company’s debt. The problem is that we have bonds only with certain maturities such as 2, 5, 10 and 30 years. For any maturity in-between, we will have to estimate the rate. The credit rating is also used as a reasonable proxy for the risk of debt.
- The analyst also needs to include leases in the debt and use the long-term borrowing rate as the cost of debt for this.
- Depending on how complex the company’s capital structure is, it gets more difficult to estimate the WACC.
- WACC is a forward looking measure and the calculations are based on expected returns, not on historical returns. So, for equity also, market value is considered not the book value.
Due to the above reasons, two analysts will rarely come up with the same value for WACC. Even if they reach the same rate, the method and assumptions made to reach it will surely be different. No wonder valuation is more art than science.