Weighted average cost of capital, or WACC in English, is an indicator of a company's financing capabilities. WACC is a method of calculating the company's capital cost based on the weighted average of the proportion of various types of capital in the company's total capital. During the calculation process, it is necessary to consider the issued common stock equity, preferred stock equity and debt, and multiply them according to their respective weights in the total capital. After adding the products, the weighted average cost of capital can be obtained. As a financial indicator to measure a company's financing ability, the higher the WACC value, the higher the company's financing costs, and the corresponding investment risks may be greater; the lower the WACC value, the lower the company's financing costs, and the corresponding investment risks may be smaller. Re: The company's cost of equity (Cost of Equity) is a somewhat subjective value. It is usually a percentage value set by investors based on their own analysis of the company and combined with the company's historical rate of return. Alternatively, the CAPM model can be used to estimate the cost of equity. Rd: The company's cost of debt (Cost of Debt), which can be calculated by dividing the company's total interest expense during the financial year by its total debt; Tc: The company's corporate tax rate (Corporate Tax Rate), which can be found in the financial reports of listed companies. For the cost of equity, you can consider using the Capital Asset Pricing Model (CAMP model) to estimate. The calculation method is: Re = Rf + β (Rm – Rf) Among them: Re: expected return on stock Rf: Zero risk rate of return. Generally, the U.S. 10-year Treasury bond rate is used as the Rf value. The current data is 2.74% [Source] Rm: Market expected rate of return, which can be calculated using the average rate of return of the S&P 500, for example: 10% β: The systematic risk coefficient of this stock to the entire stock market. For example, Apple's current β coefficient is 1.22 [Source] In the CAMP model, when the β coefficient is higher, the Re value is higher, indicating that investors’ expected return on the stock is higher. How to calculate Apple's weighted average cost of capital? This chapter will perform example calculations by using Apple's 10-K financial report released in September 2021: The income statement, balance sheet and other data tables in AAPL's financial report are as follows: Income statement: Balance Sheet: Corporate tax rate: Interest expense: Get the current share price via Apple's investing portal: It can be seen from the data graph: Number of outstanding shares 16,701,272,000 stock price $149.64 total interest expense $2,645M total debt $287,912 M corporate tax rate 13.3% So: Market capitalization E = number of shares in circulation × stock price = 16,701,272,000 × $149.64 = $2,499,178 M Debt D = $287,912 M Capital value V = E + D = $2,499,178 M + $287,912 M = $2,787,090 M = $2,787 T The cost of equity is calculated according to the CAMP model: Rf is 2.74% Average return on S&P 500: Rm = 10% Apple’s current beta: β = 1.22 So, = 2.74% + 1.22 (10% – 2.74%) = 11.60% Cost of debt Rd = interest expense / total debt = $2,645 M / $287,912 M = 0.92% Weighted average cost of capital = equity weight × equity cost + debt weight × debt cost × (1-tax rate) WACC = (E/V × Re) + (D/V×Rd×(1−Tc))
= ($2,499,178 M / $2,787,090 M × 11.60%) + ($287,912 M / $2,787,090 M × 0.92% × (1 – 13.30%)) = 10.40% + 0.08% = 10.48% What investment guidance does the weighted average cost of capital have? Investors often measure the value of a company's investment using the weighted average cost of capital, which represents the return required by investors, including debt and securities, to provide capital to the company. When the WACC value is low, it means that the company's financing costs are low; When the WACC value is higher, it means that the company's financing costs are higher. When analyzing a company, it's a good idea to compare the WACC value with ROIC (return on invested capital) to measure the likelihood of a return on investment. When ROIC is greater than WACC, it means that the return on investment will be greater than the investment cost, and it is possible to obtain returns from investment; When ROIC is less than WACC, it means that the company's investment income is less than its average investment cost, and investing in it may not yield returns, indicating that it is a higher-risk investment. At the same time, WACC can also be used as a discount rate to discount the present value of future cash flows. The higher the WACC value, the lower the discounted future cash flow value, and the lower the company's future profitability; The lower the WACC value, the higher the discounted value of future cash flows, and the higher the future profitability of the company. Within a company, WACC is also used to measure the likelihood that a company's specific projects will be carried out or further financed through debt or equity investment. The lower the WACC value, the less likely it is that project development or financing will be blocked; The higher the WACC value, the higher the possibility that project development or financing will be blocked. What are the limitations of using weighted average cost of capital? In the actual calculation process, the calculated values of the weighted average cost of capital are greatly affected by market fluctuations. Whether it is the U.S. Treasury bond yield or the company's market value, it will have a significant impact on the calculation results of WACC. Therefore, using WACC to evaluate the company's investment cost may yield different results for different periods, which will in turn lead to different investment value evaluation results. Therefore, users should combine more other objective data to conduct financial analysis and evaluation.