Weighted Average Cost of Capital (WACC)

What is the Weighted Average Cost of Capital (WACC)? 

The Weighted Average Cost of Capital (WACC) is significant for both investors, encompassing equity and debt holders, and the company seeking investment. On one hand, it represents the minimum rate of return that investors require to invest their capital in the company. Conversely, from the company’s standpoint, WACC denotes the cost it is prepared to incur in order to access those funds. 

Investment bankers utilize WACC to discount future Free Cash Flows (FCF) and arrive at a company’s intrinsic value. By calculating WACC, analysts can determine the appropriate discount rate to assess the present value of a company’s expected cash flows. On the other hand, management teams utilize WACC as a starting point to calculate hurdle rates for capital budgeting decisions, and as a benchmark against industry peers. Keeping WACC at a minimum level is essential for management to maximize the Enterprise Value (EV). 

WACC Formula and Calculation

WACC formula breakdown: 

Where, 

Kd = Cost of debt 

Ke = Cost of equity  

In this blog, we will take a detailed look at each element of WACC and highlight its related sensitivities. For illustration purpose, we will calculate the WACC of Apple (ticker: AAPL) as an example, using market data as of Jul 14, 2023. For market data, we have used the Felix analysis tool, which covers more than 7,000 companies across the US, UK, Canada, France, Germany, Italy and more.  

Cost of Debt 

When Debt is Publicly Traded 

Cost of debt can be calculated using the Yield to Maturity (YTM) of the long-term bonds with ≥10 years remaining until maturity. 

Apple bonds YTM as of Jul 14, 2023 

An alternative method we can add the credit spread as per the prevailing corporate credit rating to the government bond yield. 

Source: Felix analytics 

 We have picked 4.82% as the cost of debt. However, we have performed a sensitivity analysis later in this blog to illustrate the impact of changes in Kd to WACC. 

 When Debt is Not Publicly Traded 

Given that credit rating agencies often do not provide ratings for non-public debt, we can use the following approach: 

Assess the bond credit ratings of comparable companies obtained from agencies such as S&P, Moody’s, and Fitch. Determine the credit spread based on these ratings over the past 12 months. Calculate the average credit spread and add it to the yield of a 10-year Treasury Bond 

Tax Rate Consideration  

In the process of calculating WACC, it is essential to consider the tax obligations of the company. A significant aspect to consider is the marginal corporate tax rate applicable in the country of operation. To illustrate, the United States has a flat federal income tax rate of 21%, which has been in effect since January 1, 2018. 

However, when a company operates globally, determining the accurate tax rate becomes more challenging. In such scenarios, it is advisable to refer to the effective income tax rates disclosed in the company’s financial filings. These filings provide a comprehensive view of the company’s tax obligations, incorporating any applicable tax incentives, credits, and exemptions. Let’s look at Apple’s geographical revenue and operating income split: 

Note: As of Apr 1, 2023, Q2 2023, Form 10-Q

It is clearly visible that Apple generates more than two third of its earnings from foreign operations. So, it becomes more important to consider the effective tax rate for the WACC calculation. To ensure consistency and mitigate any potential quarterly fluctuations, we will use the full-year effective tax rate in our analysis. As disclosed in its annual filing, effective tax rate is 16.2%. Also, as per the filings – ‘The Company’s effective tax rate for 2022 was lower than the statutory federal income tax rate due primarily to a lower effective tax rate on foreign earnings, tax benefits from share-based compensation and the impact of the U.S. federal R&D credit, partially offset by state income taxes.’ 

Note: As of Sep 24, 2022, FY 2022, Form 10-K

Net Debt  

Net Debt is calculated as gross debt minus excess cash and cash equivalents. However, in practice, when considering WACC for mature companies that have an established capital structure, it is common to focus on gross debt instead of net debt. This approach is taken because these companies typically maintain a significant level of operating cash, while any excess cash is regularly utilized for share buybacks and dividends, ultimately reducing it to zero. 

Gross debt includes both short-term and long-term interest-bearing debt. Whereas cash & cash equivalents encompass cash at bank and marketable securities. 

Gross debt calculation of Apple: 

Note: As of Apr 1, 2023, Q2 2023, Form 10-Q

For overall weights, you can consider a target capital structure which can be estimated by looking at the company’s peers or management guidance, otherwise consider the current capital structure. 

Cost of Equity 

The cost of equity is generally calculated using the Capital Asset Pricing Model (CAPM), represented as: 

Risk-free rate (Rf)  

The risk-free rate or Rf is often assumed to be the yield to maturity (YTM) for treasury bonds with 10 or 20 years of maturity. 

Note: As of Jul 14, 2023; Source: Felix analytics 

We have picked 3.80% as Rf. However, sensitivity analysis has been performed later in this blog to illustrate the impact of the changes in Rf to WACC. 

For extreme situations when there is an inverted yield curve, we might want to do sanity check using historical averages and normalize the data. 

Beta (β)

Beta or β, is the slope coefficient of market model of return equation. The financial theory states that β should be forward looking which should account for uncertainty in future cash flows. There are two sources widely used in Investment Banking:

1. Predicted β from Barra: Due to its forward-looking nature, this is the most widely used β by bankers.
2. β from Bloomberg: Use adjusted β, which is an estimate of the future’s β.

Adjusted β as per Felix analytics tool: 1.17

We have picked 1.17 as the adjusted β. However, sensitivity analysis has been performed later in this blog to illustrate the impact of the changes in β to WACC.

In practice, Investment Bankers do not calculate β manually. However, you can derive the historical β based on the following calculation:

where Rm and Ri are the periodic returns of the broader market and the stock respectively.

 

Note: Based on monthly returns for last 5 years of Apple’s adjusted share price. We have taken the S&P 500 (TR) to calculate market return. Timeframe: Jun 1, 2018 to June 1, 2023. 

Unlevering and Re-levering of β 

β as detailed above, is a levered β. We generally unlever and re-lever it to accommodate the effect of target capital structure. 

Unlevering and re-levering β of industry peers is a common practice to calculate the β for privately held firm. 

Illustration Using Felix Analytics Tool 

With the Felix analytics tool, you can find the trading comparables and its market-related data including adjusted levered beta, as captured in the snapshot below. 

Based on the comparables’ current capital structure and their adjusted levered beta, we have calculated the median adjusted unlevered beta.

We have then used the median unlevered beta, accounted for the target capital structure, and arrived at the relevered beta.

Market Risk Premium

Determining the market risk premium, which represents the additional return investors expect from the equity market compared to the risk-free rate, can be a challenging task. This concept is abstract and arriving at an accurate forward-looking value is difficult. However, historical data can provide useful insights since the market risk premium has generally been within a certain range. Here are a few sources you can consider:

1. ‘Ibbotson Risk Premia Over Time Report’: This report requires a paid subscription and offers valuable information on historical market risk premiums.
2. Aswath Damodaran annual report on “Country Default Spreads and Risk Premiums”: This publicly available report provides useful data, including the equity market risk premium for the USA. (Link)
3. Felix market data: Updated US and European data on a monthly basis.
4. Range methodology: As an alternative approach, you can use a range of 4-6% for the USA market, subject to approval from your Managing Director

Market risk premium as per Felix analytics tool:

We have picked 6.64% as the market risk premium. However, sensitivity analysis has been performed later in this blog to illustrate the impact of the changes in market risk premium to WACC.

Equity Value

To determine the equity value of a company, you can use the following formula:

Where net dilution from stock options is:

Note: O/s shares as of Apr 21, 2023, Q2 2023, Form 10-Q; Current share price is as of Jul 14, 2023.

Cost of Preferred Equity

Preferred equity is a type of hybrid security that has characteristics of both debt and equity. It typically pays a fixed dividend, like debt, but it also has some features of equity, such as the right to vote on certain matters. Preferred equity is not commonly found in mature balance sheets. However, if you do encounter it, you can treat redeemable preferred shares as debt and irredeemable preferred shares as common equity when calculating the WACC at the firm level.

WACC – Final Calculation:

Finally, Apple’s WACC is 11.31%.

Download the WACC Template to practice calculating a company’s weighted average cost of capital.

Sensitivity Analysis

After determining the various components of WACC, conducting sensitivity analyses is crucial to assess the impact of changes in key inputs on the final WACC figure. Sensitivities should be performed for variables such as Kd, tax rate, Rf, β and market risk premium.

Hence, the calculated range of weighted average cost of capital (WACC) for Apple Inc. ranges from 10.538% to 12.140%. It is worth noting that Apple Inc. possesses an equity-heavy capital structure. As a result, when conducting sensitivity analyses, particular attention should be paid to two key factors: β and the market risk premium.

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Conclusion

In conclusion, the WACC is a crucial metric for both investors and companies. It represents the minimum return investors require and the cost a company is willing to incur for accessing funds. Calculating WACC involves various components such as the cost of debt, tax rate, cost of equity, market risk premium, Beta and overall weights assigned to both debt and equity. In theory, we can observe different WACCs for each projected year due to factors such as a change in capital structure, changes in interest rates etc. However, in practice, we usually consider a constant WACC over the forecast horizon to discount FCF and terminal value. Due to the numerous assumptions involved, managing WACC can be prone to errors, hence it is advisable to perform a sensitivity analysis.

Additional Resources

Capital Asset Pricing Model (CAPM)

Risk premium

Restricted Stock Units (RSU)

Employee Stock Options