an introduction the concept of WACC (Weighted Average Cost of Capital) - a must for every business owner and consumer of government services such as water and sewerage and electricity

1. Weighted Average Cost of Capital
(WACC)
– An Introduction
A’Ohlin Commercial Insights
www.aohlininsights.com
19 June 2013
A’Ohlin Commercial Insights © 2013

2. • Broadly speaking, a company’s assets are financed by either debt or equity.
• WACC is the average of the costs of these sources of financing, each of which
is weighted by its respective use in the given situation.
• By taking a weighted average, we can see how much interest the company
has to pay for every dollar it finances.
• A firm's (or a project’s or a business unit’s) WACC is the overall required
return on the firm as a whole and, as such, it is often used internally by
company directors to determine the economic feasibility of expansionary
opportunities and mergers.
• It is the appropriate discount rate to use for cash flows with risk that is similar
to that of the overall firm.
Weighted Average Cost of Capital is the percentage cost (interest) or
return required to finance a company or project by debt and/or equity
A’Ohlin Commercial Insights © 2013 Page 2

3. • “weighted average”
– proportion of debt to equity, such as 60% debt and 40% equity
• “cost of capital”
– interest rate on debt PLUS the required return on equity
– return required for putting that capital (money) at risk
• Capital = Debt capital (D) + Equity capital (E)
similar to a business’ balance sheet where Assets = Liabilities + Equity
CC = return required on debt + return required on equity
= Rd + Re
WACC = weighted average return on debt + weighted average return on equity
= (D / (D+E)) x Rd + (E / (D+E)) x Re
WACC is comprised of the “weighted average” and “cost of capital”
A’Ohlin Commercial Insights © 2013 Page 3

4. Firm is interested in investing in a new shopping centre or commercial
development
 it should go ahead if the returns forecasted to be generated are at least equal
to the WACC
 if they are below the WACC, then the project is not expected to generate
enough return to compensate those providing the debt (usually the banks)
nor is it sufficient to compensate the owners (equity) for also risking their
money
WACC is used as a hurdle rate when making investment decisions
A’Ohlin Commercial Insights © 2013 Page 4

5. • In a firm’s Profit & Loss statement, interest on debt is regarded as an EXPENSE
• As such, it effectively reduces the firm’s profit and amount of tax to be paid
TAX SHIELD
To account for this TAX SHIELD effect on debt, the WACC is adjusted as follows:
As interest on debt is an expense which reduces profit and thus reduces
the amount of tax payable, an adjustment is made to WACC
A’Ohlin Commercial Insights © 2013 Page 5
Where: E = amount of equity invested
D = amount of debt invested
V = total value or amount invested i.e. V = E + D
Re = required return on equity
Rd = required return on debt
Tc = corporate tax rate
In the case of water utilities:
The higher the WACC => the higher
required revenue
The lower the WACC => the lower
the required revenue

6. Cost of Debt (Rd)
• usually the interest rate charged by the banks or funding institutions
Cost of Equity (Re)
• more difficult to determine
• based on the Risk Free Rate (Rf)
– A common proxy for Rf is the 10 year government bond rate
• PLUS a premium for investing in a “riskier asset”
– i.e. investing in a business or project is usually regarded as more risky than
investing in a risk free asset such as a10 year government bond
A’Ohlin Commercial Insights © 2013 Page 6
Historical WACCs, particularly those used by the public sector, are
no longer applicable in today’s environment

7. Cost of Debt (Rd)
• Interest rates have plummeted
• Cost of raising debt is at an all time low
Cost of Equity (Re)
• Risk Free Rate (Rf)
– 10 year government bond rates at an all time low
– Australia is one of a handful of countries retaining AAA credit status
• We can borrow money in international markets at cheaper rates because we are
considered to be “less risky” or “more credit worthy”
• Premium for investing in a “riskier asset”
– 6% Market Risk Premium has been Australia’s historical average to 2010
– since December 2010, the global market has materially changed with Australia
now being regarded as relatively safe, and thus driving down our Market Risk
Premium
A’Ohlin Commercial Insights © 2013 Page 7
Historical WACCs, particularly those used by the public sector, are
no longer applicable in today’s environment (continued)
For more information
see “Cheaper Prices -
WACC - Post GFC a
Revision Lower is
Needed”

8. Weighted Average Cost of Capital
(WACC)
– An Introduction
A’Ohlin Commercial Insights
www.aohlininsights.com
19 June 2013
A’Ohlin Commercial Insights © 2013