Looking for a way to measure the ability of company managers? Consider WACC…

Julie Brownlee, Fsp Invest, 22 Dec. 2014

Tags: wacc, weighted average cost of capital, investing, how to calculate wacc, what is wacc, measure company management ability

When you invest in shares, you want to know whether you’ll be adequately compensated for the risks you take on as a shareholder.

So how can you do this?

You can calculate a company’s weighted average cost of capital (WACC).

Read on to find out how to do this…

What is WACC?

Weighted average cost of capital (WACC) is the rate of return a company must make on the money shareholders have in the company to stop investors putting their money elsewhere.

In other words, it’s the company’s cost of money.

How to calculate WACC

To calculate WACC, you need the weighted average of the cost of borrowing money from banks or bondholders, in other words debt, and shareholders (equity).

The cost of debt is the interest rate a company pays to borrow, minus the company’s tax rate. You take the tax rate into account as it reduces a company’s taxable profits.

Equity costs a company more than debt. This is because shareholders receive payment last so they need to receive more to reflect this.

So how much more do shareholders need? This is subject to debate and there isn’t a right answer.

It comes down to two things:

  • How much debt a company has; and
  • How risky the underlying business is.

For example, say Company ABC is half-funded by debt at 5% and half-funded by equity at 10%. WACC is (0.5 x 5%) + (0.5 x 10%) = 7.5%.

If you want to measure the ability of managers at a company, WACC may be a better alternative to earnings per share (EPS).

When interest rates are low, managers can boost a company’s EPS by using more debt to fund the company. But this might not earn enough of a return to compensate shareholders for the risks they take on investing in the company.

So there you have it, how to use WACC to measure the ability of company managers.

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