Have you ever wondered why we need to consider the cost of capital as well, not just the expected returns?

Yesterday, I was analyzing a new investment project for the company and realized that most investors tend to focus only on the returns they will receive, but forget to think about how much it costs to raise the funds to carry out the project. That’s where WACC comes in, which stands for Weighted Average Cost of Capital, or the average cost of capital.

Why do we need to calculate WACC? Because most companies don’t raise funds from a single source. Some come from borrowing, some from shareholders. Each source has a different cost. The cost of bank loans is the interest rate paid, while the cost from shareholders is the expected return they seek. Knowing the overall average cost is key to making good investment decisions.

If you want to calculate WACC, the formula isn’t as complicated as you might think. WACC equals (debt ratio × interest rate × (1 - tax rate)) plus (equity ratio × expected return). It looks complex, but try plugging in real numbers.

Imagine Company XYZ has 100 million baht in debt (60% of total capital) and 160 million baht from shareholders (40%). The loan interest rate is 7%, corporate tax rate is 20%, and shareholders expect a 15% return. Plugging these into the WACC formula gives approximately 11.38%. This is the average cost of all the capital raised.

Using this result is straightforward. If the expected return (15%) is higher than WACC (11.38%), it’s worth investing. But if it’s lower, it’s not worthwhile.

However, be cautious of some limitations of WACC. It doesn’t account for future changes, such as rising interest rates or project risks that might differ from the average. Also, calculating WACC requires current and accurate data, which can sometimes be hard to obtain or change frequently.

A tip for using WACC effectively is not to rely on it alone. It should be compared with other indicators like NPV (Net Present Value) or IRR (Internal Rate of Return). And most importantly, update the WACC regularly because market conditions are always changing.

In summary, WACC is a tool that helps us see the true overall cost of raising capital, not just the expected returns. When used correctly and with an understanding of its limitations, it can help us make smarter investment decisions.