3 Reasons to Care About Weighted Average Cost of Capital (WACC) as a Small Business Owner
March 23, 2022
March 23, 2022
In this article, you‚Äôll learn:
As a small business owner, you have to finance your company‚Äôs operations through equity, debt, or a combination of the two types of capital. This equity or debt financing is provided by investors ‚Äď and these investors want to see a positive rate of return.
When you think of an investor, ‚Äúventure capitalist‚ÄĚ or ‚Äúangel investor‚ÄĚ may be the first terms that come to mind. But a bank that lends money to a small business owner is also an investor ‚Äď the interest rate on the business loan is their targeted rate of return. You could even be an investor if you finance your small business through your savings ‚Äď in this example, you expect the business to produce an amount above your initial investment.
The overall return expected by investors can be expressed as your weighted average cost of capital.
The weighted average cost of capital (WACC) takes each category of a firm‚Äôs capital ‚Äď common stock, preferred stock, bonds, and other types of debt ‚Äď and weighs it proportionally to arrive at a blended cost of capital.
All things being equal, a firm‚Äôs WACC is lower if future cash flows are highly likely to come to fruition. The firm‚Äôs WACC is higher, on the other hand, if there is a lot of long-term uncertainty.
How to Calculate Weighted Average Cost of Capital as a Small Business Owner
Since the WACC is the blended cost of capital, it is calculated by multiplying the cost of each source of capital by its percentage of total capital ‚Äď and adding these components together. The debt piece of the puzzle is adjusted by the corporate tax rate.
WACC=(E/V √ó re)+(D/V √ó rd √ó (1‚ąíT))
E = Market value of the firm‚Äôs equity
D = Market value of the firm‚Äôs debt
V = E + D
re=Cost of equity
rd=Cost of debt
Tc=Corporate tax rate‚Äč
Here‚Äôs an example to illustrate the calculation:
The equity is 66.7% of total capital ($500,000/$750,000). From there, you take .667 and multiply it by 12%, giving you 8%.
The debt is 33.3% of total capital ($250,000/$750,000). You take .333 and multiply it by 9%, giving you 3%. The next step is to multiply 3% by (1 ‚Äď .2), which works out to 2.4%.
You add the 8% and 2.4%, giving you a weighted average cost of capital of 10.4%.
Seems easy right?
While the cost of debt is easily determined through the agreed-upon interest rate(s) of the debt, the cost of equity has to be estimated.
The capital asset pricing model (CAPM) is often used to calculate the cost of equity. Here‚Äôs the formula.
‚ÄčEri ‚Äč = Rf ‚Äč+ ő≤i ‚Äč(ERm‚Äč‚ąíRf)
Eri ‚Äč= expected return of investment
Rf‚Äč = risk-free rate
ő≤i‚Äč = beta of the investment
(ERm‚Äč‚ąíRf‚Äč) = market risk premium‚Äč
This may seem complicated if you don‚Äôt have a background in finance, but here‚Äôs what you need to know as a small business owner:
There is no consensus market-risk premium, as it depends on the period and investment used to determine the risk-free rate of return. The estimated risk premium seems to have decreased due to higher company valuations in recent years, and may currently be as low as +1.5% to +2.5%.
As a small business owner, your company is likely not publicly traded, so this brings us to another complication: you can‚Äôt use stock prices to estimate beta. You‚Äôre not out of luck, however, as there are ways to calculate the beta of a private company.
Do you lack the time or expertise to determine your cost of equity?
If so, you may want to get help from a Certified Public Accountant (CPA) ‚Äď they can help your business with a variety of issues outside of tax season.
Why Should Small Business Owners Care About WACC?
It‚Äôs not easy to calculate the WACC for your small business, but it‚Äôs definitely worth the trouble. Here are three reasons to care about weighted average cost of capital as a small business owner:
As a small business owner, you are constantly evaluating internal investment opportunities. Should you invest in a piece of equipment? Is that marketing campaign a good idea? Is a company vehicle worth buying?
You could go with your gut on these investment opportunities, but you‚Äôd be better off calculating the expected return on these internal investments and comparing them to your WACC.
Here‚Äôs a simple example:
You have the opportunity to do a marketing campaign for $10,000. You expect it to provide $12,000 in value to your small business in exactly one year, which equals a 20% return on your investment (ROI). So, your WACC would have to be lower than 20% for the marketing campaign to be financially viable.
You can turn to a discounted cash flow (DCF) model for more complex calculations. With a DCF model, you calculate the present value of a project by applying a discount rate to all of the projected future cash flows.
In many cases, you won‚Äôt be able to come up with a precise expected ROI for a new project. You are also going to have a tough time pinpointing your WACC if you have a private company. But it‚Äôs still a valuable thought exercise to help determine the best course of action. Say you expect the marketing campaign to provide a 300% ROI ‚Äď or a 3% ROI. In either scenario, you have an important piece of data to inform your decision-making.
Are you thinking about acquiring an existing small business?
You might be able to create a combined organization that is greater than the sum of its parts. Or get a bargain on a business with high projected future cash flows.
To purchase a small business, you may have to use equity financing and/or debt financing‚Ä¶ and the WACC calculation is going to determine the viability of the investment. With this decision, you‚Äôre going to need to do a DCF analysis, as a business acquisition could impact your balance sheet years ‚Äď or even decades ‚Äď into the future.
You may be wondering:
How could I possibly know how much cash flow the business is going to provide 5+ years into the future?
The answer is that there‚Äôs no way of knowing.
But the DCF model accounts for this. You can estimate your cash flows over the first five years of the business acquisition and apply a terminal value to account for the acquisition‚Äôs value beyond the forecast period. You can use either the perpetual growth (Gordon Growth Model) or exit multiple methods.
A business acquisition is typically much larger than any individual internal project, so you may want a sizeable margin of safety.
Say the business costs $500,000 and the DCF model gives you a present value of $525,000. You may want to go ahead with the acquisition if there are non-financial benefits, but if it‚Äôs purely a financially motivated acquisition, you might want to give it further consideration. While it‚Äôs possible that you underestimated the future cash flows, an overestimation could be catastrophic for your small business with such a small margin.
Have you ever looked at a list of companies that have low interest payments relative to their debt? The company‚Äôs cost of debt is likely low because investors believe there is a low chance the company is going to default on its debt. According to the Motley Fool, Amazon borrowed $10 billion at a weighted average cost of debt of 1.76% back in 2020. This is a rare situation, as Amazon is one of the biggest companies in the world, but it shows that there‚Äôs a high correlation between interest expense and financial health.
There isn‚Äôt a single number with equity capital that gives us as much information on a company‚Äôs financial health as interest expense on debt. But the combination of a company‚Äôs projected future cash flows and the current market price is meaningful. For example, you have two companies with projected 3-5% earnings and sales growth over the next five years ‚Äď Company A trades at 20x earnings and 5x sales, and Company B trades at 12x earnings and 3x sales. Company A likely has a much lower WACC than Company B ‚Äď based on the equity valuation.
Here’s a way to look at the market value of equity: investors are paying $20 for every $1 of earnings from Company A and $12 for every $1 of earnings from Company B.
You shouldn‚Äôt compare your WACC to Amazon‚Äôs ‚Äď or any company that is much different from your small business. You should instead determine the WACCs of similar businesses, if possible. If your WACC is much higher than average, you should reevaluate your business strategies. If it‚Äôs lower, you‚Äôre doing something right ‚Äď and might not want to make any big changes to your business.
Your company‚Äôs WACC is one of the most important metrics for your small business. The WACC formula is complex and you may have to estimate some of the inputs, but doing the WACC calculation is still a worthwhile activity ‚Äď even if it isn‚Äôt 100% accurate ‚Äď as it informs so many key decisions for your small business.
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