WACC: A Common Way to Calculate the Cost of Invested Capital

Now let’s discuss how to calculate the cost of invested capital. 

Just now we discussed who the investors are, i.e. people that would put money into the company. They are creditors of interest-bearing liabilities and shareholders. 

When I borrow money from creditors, would there be any costs? Apparently so. 

But what is the cost? When I borrow money from, say, the bank, there will be interest rates that I will have to bear. That will be my cost of using money from creditors.

But what about shareholder’s money? Does it have costs?

We know that if we use shareholder’s money, we don’t need to pay interests. However, we do need to pay dividends to shareholders. However, dividend payment is voluntary, and no company is forced to give out dividends. In other words, unlike paying back banks with principals and interests, which is protected by laws, a company that doesn’t pay dividends won’t get punished by the law. 

For instance, Berkshire Hathaway, the company led by the world-famous investor Warren Buffett, is famously known to not pay any cash dividends to its shareholders in the history of the company's existence. However, this hasn't stopped investors from pumping money into the money and snatching up the company's stocks, pushing its share prices higher and higher. This just shows that a company can use shareholders’ money without paying dividends.

Therefore, this means that using shareholder's money will have zero cost right?

Wrong. Big time. 

When a shareholder invests in a company, she automatically loses the opportunity to use the same capital to invest in any other company in the world. What this statement describes is the concept of opportunity cost; the money that a shareholder could have earned by investing in another company represents the cost when he chooses this company.That’s why we call it opportunity cost. Whenever a shareholder invests in one company, he bears such an opportunity cost because he bears the cost of giving up another opportunity.

So what does a shareholder want? He wants to gain return higher than cost. To put it another way, his return is the return of the invested company. His cost is the opportunity cost, which is the return that he could get if he invested in another company. So when he requires returns higher than the cost, it means he hopes this company can generate returns higher than other companies. 

This is a fairly simple idea. For example, let's assume that one year ago, there were three investment opportunities in front of me. I chose one of them, automatically giving up on the other two. After one year, I wanted to compare how much I could have earned if I invested in the other two companies. Only when the company I invested in earned the highest returns among the three could I be satisfied. Otherwise, even if this company makes money but less than the other two, I will still regret my decision, because I gave up investing in better opportunities.

Now that we've understood that the cost to shareholders is opportunity cost; however, since paying dividends is not protected by the law, I can simply ignore them. Can it be done this way? 

Well in a market economy, there will be repercussions. Why? 

As the manager of a company, who hires him? Shareholders. If he can’t give shareholders the required returns, shareholders can change the management with new ones. Even though the shareholder may not be that influential because he is not holding enough stocks, lacking the power to change management of the company, he can vote in other ways. He can withdraw all his holdings from the company to protect himself. If it happens on a massive scale, i.e. when lots of investors sell a company's stocks in a short period of time, the stock price will drop, eventually causing the dismissal of the management anyway. Such a company can’t survive in the market. That’s why in a market economy, if shareholders ask for returns, the company must provide. 

How much return do shareholders normally ask for? 

We know that an investor's cost is the opportunity cost that he loses in investing in other companies. But which other companies? 

The companies should have similar risks to the company we've invested in. For example, some businesses involved in illegal activities are inherently more lucrative and risky at the same time, and their returns shouldn't be taken as our opportunity costs. Normally we'd choose companies from the same industry since they share similar risk levels. These companies may make more money or less, and we will use the average return of the industry as our standard of the opportunity cost.

There are two ways to measure the average return of an industry. One is to use the average return on investment in the stock market of that industry to find out the cost. Another way is to calculate the average profitability of the companies in that industry. Here we will use the latter method.

Assuming that we have calculated the cost of capital from creditors and that from shareholders, the next step is to find out the cost of invested capital. A common way of calculation is the weighted average method. For example, let’s assume that 40% of my funds come from creditors with an interest rate of 7%, and 60% come from shareholders. Assuming that the average profitability of the industry is 12%, then we know the cost of invested capital should be calculated as 40% × 7% + 60% × 12% = 10%. The cost of invested capital calculated by the weighted average method is called weighted average cost of capital, or WACC. WACC is the standard of measuring whether a company generates a positive or negative return.

However, there is a minor mistake in the calculation of WACC. Let's look at an example. 

Assuming there are two companies and their EBITs are completely the same, say 100 dollars. Recall that EBIT refers to the profit before interests and income taxes. How do we get the profit? You may remember that the company gets the net profit after paying interests and taxes, so if we add taxes and interests to the net profit, we will get EBIT or earnings before interests and taxes.

We assume the EBIT of the two companies are the same, and their income tax rates are both 25%. The only difference is that one company borrows money from the bank, while the other one has no loans. For the company having no bank loans, its EBIT is 100 without interest expense. Then we deduct the income tax, or 25% of EBIT, resulting in 75 dollars of net profit.

Now let's look at the other company with interests. The company has an EBIT of 100, but it needs to pay the bank 20 for interest. After paying the interest, the profit of the company becomes 80 dollars. The company then pays 25% of the 80 dollars as income tax, resulting in a net profit of 60 dollars.

If we compare these two companies, we will discover that the second company pays 20 dollars more than the first company for interest, but its profit is only 15 dollars less. Where is the other five dollars?

The reason is simple. The income tax of the second company is actually 5 dollars less than that of the first company. Even though it needs to pay 20 dollars worth of interest to the bank, 5 out the 20 dollars are actually "paid" by the government. 

This sounds like too good to be true; however, it actually is the case. Since the company pays income tax after interest, the more interest it pays, the less the EBIT the company has, and the less income tax it has to pay to the tax bureau. We call this effect the tax shield of interest. Due to this effect, we now know that although a company pays 20 dollars of interest to the banks, it only bears 15 dollars by itself, or 75%. In this sense, if the interest rate of a bank loan is 7%, now we know the cost we bear is not exactly 7%, but 7% × (1-tax rate). If the tax rate is 25%, out de facto interest rate will be 7% × 75%, or around 5%. This is how we calculate WACC.