Mastering WACC: Key Adjustments and Practical Examples

Understanding the Weighted Average Cost of Capital with Multiple Financing Sources

The Weighted Average Cost of Capital (WACC) is a crucial financial metric used by firms to assess their cost of financing. It's essentially the average rate of return a company is expected to pay its security holders. When a company has more than two sources of financing, the WACC formula needs to be adjusted accordingly.

Traditionally, the WACC considers the cost of equity and the cost of debt. However, companies often have a third component: preferred stock. The cost of preferred stock is determined by the dividends paid to preferred shareholders, and its proportion in the overall capital structure. Thus, the WACC formula now includes the cost of common stock, the cost of preferred stock, and the cost of debt to reflect all three financing components.

The Impact of Short-Term Debt on WACC

It's a common oversight for companies to exclude short-term debt when calculating WACC. However, short-term debt holders, like their long-term counterparts, have a claim on the company's earnings. Ignoring this could lead to an understated WACC, which in turn can result in inaccurate investment decisions. Therefore, the cost of short-term debt should be incorporated into the WACC calculation, usually by breaking the cost of debt into two separate components: one for short-term and one for long-term debt.

Addressing Other Current Liabilities

When it comes to other current liabilities, the approach is different. These are typically offset against current assets, and the net amount is reflected as net working capital on the balance sheet. Since these liabilities are already accounted for in this way, they are not usually included in the WACC calculation.

How to Calculate the Costs of Financing

Calculating the cost of equity can often be done using stock market data and the Capital Asset Pricing Model (CAPM). The cost of debt is more straightforward, as it's based on the interest rate at which the company borrows from lenders. Once these costs and the respective proportions of debt and equity are known, calculating the WACC becomes a matter of applying the formula.

Company vs. Industry WACC

Sometimes, companies compare their WACC with the industry average. This benchmarking can indicate whether a company is performing better or worse than its peers in terms of its cost of capital.

Adjusted Present Value: Incorporating Financing Effects

When considering project financing, companies can adjust for the financing effects in two ways: by adjusting the discount rate or by adjusting the present value. The Adjusted Present Value (APV) method takes the base case NPV and adjusts for the financing side effects, such as the tax shield from debt. The discount rate for the tax shield should reflect its risk, which is typically lower than that of the project's cash flows.

For example, if a project has a positive NPV but the costs of issuing new stock to finance the project are greater, the APV may become negative, rendering the project unviable. Conversely, a project with a negative NPV can become viable if the present value of the tax shield from debt financing is significant enough to result in a positive APV.

Practical Examples

Let's consider two scenarios:

1. Project A has an NPV of $150,000, but requires issuing stock with brokerage costs of $200,000. Although the NPV is positive, the adjusted NPV becomes negative when considering these financing costs, making the project unattractive.

2. Project B shows a negative NPV of $20,000. However, if the company can issue debt at 8% and the present value of the tax shield is $60,000, the APV turns positive to $40,000, making the project potentially attractive.

These examples highlight the importance of incorporating financing effects into project evaluations to avoid misjudging a project's viability.

In summary, understanding the nuances of WACC and its adjustments is crucial for making informed financial decisions. It's essential to consider all sources of financing, the inclusion of short-term debt, and the impact of other liabilities. Furthermore, the concept of APV can significantly alter the perceived value of a project when financing side effects are considered.

For a more detailed discussion and examples on WACC adjustments, watch the full video here.