Running a company is not cheap. It generally cannot be done on cash alone. Even if it could, that's not a prudent thing to do. It is financially smart to have some cash reserves on hand. That said, the cost of doing business must be paid from somewhere, and it’s usually with capital raised through various sources.

These sources are often a combination of money raised through listing shares on the stock exchange, the value of which is known as the company’s equity, or by issuing interest-paying bonds or taking commercials loans, which are debts that the company must pay back.

Obviously, these non-cash sources of revenue cost money to obtain, as anyone who has ever taken out a personal loan or used a credit card will attest. The amount that each source of funding costs will vary depending on the source.

Weighted Average Cost of Capital

A company’s weighted average cost of capital, commonly abbreviated as WACC, is a calculation of a business’s cost of capital, which essentially is the required return necessary to make a capital-budgeting project worth undertaking.

When a company decides to take on a capital project – such as a new factory – it uses the cost of capital figure to weigh whether the investment is worth the expense of resources as opposed to the cost. The figure is also used by investors to decide if it’s worth the risk.

There are many ways in which a company can accrue capital, whether it is through credit, equity in current assets or other sources of income earned through business practices. Typically, a company will use a combination of debt and equity to finance the business.

WACC is essentially the average after-tax cost of attaining those sources of funding; it’s the average rate that the company can expect to pay to finance the assets that it has.

If a company has a high WACC, then it is usually a signal of a higher risk to investors, because it means that a company needs a lot of cash to pay its debt burden. If it’s going to take on more debt to finance a capital investment, the company is going to have a lot of explaining to do.

Why is WACC Important?

When a business firm is ready to take on a huge capital project – a long-term and expensive project with the purpose of expanding its assets – it can be a huge undertaking, both financial and otherwise. Most capital projects are infrastructure improvements or additions and can include constructions projects like roads, buildings, roadways, power plants and pipelines.

In businesses, a capital project can include new warehouses, new manufacturing equipment for a new product line or even computer systems to help streamline operations.

Most companies don’t have the cash readily available to pay for these projects. Most will need to pay the bill using sources of funding including bonds, grants, bank loans, cash reserves, additions to the company operating budget and other private funding. Needless to say, investors, lenders and shareholders will want to know lots of information about whether the capital investment will be worth the cost before moving forward.

For instance, if a new line of products requires an investment in equipment, the company will have to give some level of assurance that the product line will turn a profit.

How Is WACC Calculated?

The formula for WACC is quite complicated, but it helps to understand what it all means. In its simplest explanation, the WACC represents the company’s cost of raising $1 of funding.

If a company’s WACC is 5.8%, that means it must pay investors an average of $0.058 for every dollar in funding.

That doesn’t sound like a lot of money on its own, but take it a step further using a WACC example of a company that needs to raise $10 million in funding to pay for a new factory and equipment for a new product line. The company could sell 60,000 shares of its stock at $100 each to raise the first $6,000,000.

Shareholders will expect a return of 6% on their investment, so the cost of equity is 6%. The company then sells 4,000 bonds for $1,000 each to raise the remaining $4,000,000 in capital. The people who bought those bonds expect a 5% return, so the cost of that debt is 5%.

If you’re up for some math try to calculate using this WACC example:

First, consider the percentage of the company’s financing that consists of equity and multiply it by the cost of equity. Then, take the percentage of current financing from debt, multiply by the cost of that debt and multiply the result by one, minus the effective marginal corporate tax rate. Adding the two results gives the WACC.

For example, if a company gets half of its financing from debt and half from equity and it wants to raise $1 million, it will need to first determine the cost of equity, which again is the return investors expect when they buy stock in the company. The company also needs to know the cost of debt or the return it can get on bonds it issues.

Assuming a 5% cost of equity and a 3% return on bonds, and a 15% corporate tax rate, if the company issues $500,000 in equity and $500,000 in bonds, the formula for computing the calculation for this WACC example will be as follows:

WACC = (500,000/1,000,000)(.05) + (500,000/1,000,000)(.03)(1 - .15) The result is .03775, or 3.775%, so the company will pay 3.775% to raise the $1 million.

Corporate Taxes and Tax Shields

The rate of corporate tax that companies pay in the U.S. plays a major part in determining WACC because as tax rates go up, the WACC falls. Higher taxes impact the WACC calculation because a lower WACC is much more attractive to investors. Ironically, when corporate tax rates rise, it means that the cost of financing debt will decrease because corporate taxes, as well as all current expenses required for the operation of the company are fully tax-deductible.

Investments and real estate purchased for the intent of generating income are also deductible. To use the previous example, if the corporate tax rate doubles to 30%, using the formula, the taxes impact the WACC calculation because the company’s WACC actually decreases two-tenths of a percent to 3.55%, which looks much better to investors deciding whether or not to fund that capital project. This is why when the corporate tax rate is raised, most companies aren’t necessarily panicking about it.

Changes in Tax Rates and Using Tax Shields

Also, companies know there are other ways to cut their tax burden. For instance, the current corporate tax rate in 2019 is a flat 21%. Prior to tax reforms in 2017, it was as high as 35%. Using something called a tax shield, taxes impact the WACC calculation because some businesses are able to get their tax rates down to less than 18%.

How do they do that? Many other costs that a business incurs (besides debt costs) are also tax-deductible. Things like employee salaries, health benefits, tuition reimbursement and bonuses are common WACC tax shields.

A company can also reduce its taxable income by deducting insurance premiums, travel expenses, bad debts, interest payments, sales taxes, fuel taxes and excise taxes. Tax-preparation fees, legal services, bookkeeping and advertising costs are also used to reduce business income.

Depreciation of Business Assets

Another WACC tax shield that is commonly used by businesses is depreciation. A company’s material assets such as vehicles, buildings and machinery get older with use and therefore become less valuable. Basically, the use of depreciation as a tax shield is most applicable in businesses that have large amounts of fixed assets that get older with use and therefore carry less value with use.

It stands to reason that the Ford dump truck that your construction company owns won’t be worth the same amount of money after it’s been used for another five years.

By using a depreciation WACC tax shield, the estimated amount of depreciation is subtracted from taxable income. The amount by which depreciation shields the taxpayer from income taxes is the applicable tax rate, multiplied by the amount of depreciation.

For example, if the applicable corporate tax rate is 21% and the amount of depreciation that can be deducted is $100,000, then the depreciation tax shield is $21,000.

Choosing Debt vs. Equity

As can be seen, when considering the WACC, it sometimes makes more sense for a company to take on more debt for a few reasons. The most common reason is that paying interest on debts reduces the tax burden that the company pays, and it also means that the company doesn’t have to sell off equity. Doing so would reduce the value of the company stock, and that would mean less payout for the investors.

In many ways, taking on debt is actually less expensive than giving up equity in your company. It sounds counterintuitive, because taking on debt will always cost money in interest and other fees.

But look at it another way: A company starts with its equity, which is its value to shareholders. By raising money through equity financing, you are selling ownership in your company in return for cash.

Loss of Ownership by Selling Equity

This sounds like a seemingly good idea, until you realize that you lose ownership in your company and in addition, you may have actually saved money over the long run by taking out a bank loan or another form of debt.

For example, say you run a small business and need $40,000 in financing. If you choose to take on debt, you can take out a $40,000 bank loan at a 10% percent interest rate, which is a fairly decent rate. If your credit is in good standing, most businesses can secure a reasonable interest rate from most banks that deal with small businesses. As an alternative, you could sell a 25% percent stake in your business to investors for $40,000.

Now assume that your business earned a $20,000 profit during the next year. If you took out the loan with the bank, the interest cost of taking out the bank loan (cost of debt financing) would be $4,000, leaving you with $16,000 in profit. In addition, carrying the debt and paying interest is deducted from earnings before income taxes are levied, thus acting as a tax shield, which again lowers your WACC.

Benefits of Equity Financing

On the other hand, if you used equity financing, you would have zero debt (and as a result, no interest expense), but would keep only 75% of your profit, because the other 25% would go to your investors. Your personal profit in this case would only be $15,000, or (75% x $20,000).

You can see how it can actually be less expensive for you, as the original shareholder of your company, to issue debt as opposed to equity. You retain control of any profits, and while, yes, you’ll have to pay back debts, at the end of the day you still have equity in your company once the debt is paid off.

For the WACC, the bottom line is the cost of the capital you require.