As an African tech founder with big dreams but limited resources, you're always looking for ways to maximise your resources. This requires an understanding of weighted average cost of capital.

Weighted average cost of capital (WACC) is the average cost of capital a business expects to pay to fund its operations.

Without a clear understanding of WACC, you risk making costly mistakes that will scare away investors and stunt your business growth.

This article provides a guide on WACC importance, how to calculate it, its limitations, pitfalls, and variations based on startup type.

Let’s get started!

Understanding WACC

WACC examines the capital structure of a business and compares its debt and equity to their respective proportions. Debt often involves the company's interest rates and loan payments, whereas equity may include dividend payments to investors.

Startups need to understand WACC to make better decisions about their finances and attract more investors to their businesses.

Why is WACC important?

WACC is important in accessing the overall financial health of a startup and helps in decision-making. Knowledge of WACC also helps a startup maximise its efforts in raising startup capital and bargaining better terms with possible investors.

Furthermore, the weighted average cost of capital is helpful in capital budgeting decisions as it offers a framework for determining the viability of projects and efficiently allocating resources. 

Startups can optimise their financial structures and improve the long-term viability of their businesses by understanding WACC. 

What is WACC used for?

The calculation of a company’s WACC is useful to investors, investment bankers, startups, company management, and financial analysts in their decision-making processes. 

Individual investors use it to identify whether or not to invest in a business.

For example, a business with a 30% return and a 16% WACC generates an excess return of $0.14 per $1 invested, indicating profitability. If the return is below the WACC, the investment is unfavorable, leading to value loss.

What is a good WACC score?

The notion of a "good" weighted average cost of capital (WACC) score is contingent on several factors, including market conditions, tax rates, dividend policies, and economic conditions— as such, there is no fixed value. 

The business can manage certain factors while others remain beyond its control.

The controllable factors are: 

• Capital structure – the amount of equity or debt a business uses to fund its operations.
• Dividend policy – A policy that states how a firm will distribute its dividend to shareholders.
• Investment policy – It identifies the major risks and concerns that could affect a business and provides solutions against such risks.

The uncontrollable factors are:

• Market conditions – The market situation at a given time, including the number of competitors, rate of growth, and interest rate.
• Tax rate – The percentage of income to be paid as tax.
• Investors’ risk aversion rate –The tendency of investors to avoid risks.

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WACC changes affect startup investments. Higher WACC means riskier investments, requiring startups to seek higher returns for riskier projects.

WACC changes can impact financial planning. Startups should review WACC regularly for smart decisions on growth and resource use, considering market conditions, cash flow, industry shifts, and internal finances.

How to calculate the weighted average cost of capital for your startup

A company's weighted average cost of capital is determined by comparing its cost of debt with its cost of equity. Accurate WACC calculations help startups make sound financial decisions. 

WACC formula

There are two parts to the weighted average cost of capital formula:

• The first multiplies the cost of equity by the proportion of equity in the capital structure of the business.
• The second calculates the proportion of debt in the capital structure and multiplies it by the cost of debt.

The formula:

‍It consists of:

‍E = Market equity value

V = Total value of capital E+D

Re = Cost of equity

D = Market debt value

Rd = Cost of debt

Tc = Corporate tax rate

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Components of weighted average cost of capital

The weighted average cost of capital equation comprises several components, each contributing to the overall assessment of the cost of capital. It includes:

• Market equity value – The total value of a company’s equity, also known as market capitalisation. It is a market evaluation of the current worth of a company.

• Market debt value – The market price at which investors would be willing to buy a company’s debt.

• Cost of equity – The rate of return required by an investor in exchange for a given investment.

• Cost of debt – The total amount of interest owed on liabilities.

• Corporate tax rate – The percentage of a company’s profits paid to the government.

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Example calculation

Let's consider a hypothetical startup, XYZ Tech, to illustrate the calculation of the weighted average cost of capital. For simplicity, we'll assume the following data:

• Market Value of Equity (E): $1,000,000
• Market Value of Debt (D): $500,000
• Cost of Equity (Re): 12%
• Cost of Debt (Rd): 6%
• Corporate Tax Rate (Tc): 25%
• Total value of capital E+D: $1,500,000

Equity side of the formula

The equity side of the weighted average cost of capital formula involves calculating the cost of equity (Re) using the Capital Asset Pricing Model (CAPM):

‍Where:

• Rf = Risk-free rate, assumed to be 3%
• β = Beta, a measure of stock volatility, assumed to be 1.2
• Rm = Market rate of return, assumed to be 10%

Re = 0.03 + 1.2 x (0.10 - 0.03)

Re = 0.03 + 1.2 x 0.07

Re = 0.03 + 0.084 

Re = 0.114  

The cost of equity (Re) for XYZ Tech is calculated to be 11.4%.

Debt side of formula

Rd(1 - Tc) = 0.12(1-0.25) 

Rd(1 - Tc) = 0.12 x (0.75)

Rd(1 - Tc) = 0.045

The adjusted cost of debt (Rd) for XYZ Tech is calculated to be 4.5%.

Calculating weighted average cost of capital formula

Where:

• E = Market Value of Equity = $1,000,000
• D = Market Value of Debt = $500,000
• V = Total Value of the Firm = E + D = $1,500,000

Substitute the values into the formula:

WACC = [(1,000,000/1,500,0000) x .114] + [(500,000/1,500,0000) x .045]

WACC = 0.66670.114 + 0.33330.045

WACC = 0.0756 + 0.015

WACC = 0.091

The Weighted Average Cost of Capital (WACC) for XYZ Tech is calculated to be 9.06%.

Analysing the results

This calculation demonstrates how to compute WACC by separately calculating the equity component (cost of equity) and the debt component (cost of debt adjusted for taxes), then combining them using the appropriate weights based on the equity and debt market values.

Analysis of the result:

• 9.10% is the amount that XYZ Tech must make from its investments to pay its expenses.
• A project or investment is considered successful if the rate of return given is more than 9.06%, surpassing the current cost incurred by the business.
• A higher WACC score (like 9.10%) indicates a higher level of risk for the business; therefore, XYZ Tech must carefully control risks to minimise expenses carefully. 
• When XYZ Tech uses WACC as a guide, it can make well-informed decisions about borrowing money, dividend payments, and growth rate of the business while controlling expenses. 

Overall, WACC analysis helps XYZ Tech make informed plans, select profitable investments, manage risks, and achieve sustainable growth.

Common mistakes to avoid when calculating WACC.

Common mistakes to avoid when calculating WACC:

1. Using book value over market value – 

Book value is based on historical costs, whereas market value considers the present values of the assets. WACC calculations are guaranteed to be accurate and up-to-date when market value is used. 

Market value impacts the cost of debt and equity by demonstrating how investors value the organisation. Book value may misrepresent investor opinion. 

2. Inaccuracy in the cost calculation –

It’s better to calculate WACC with accurate figures rather than assumptions. Assuming that the cost of the present investment will be the same as the prior investment will greatly affect the WACC score. 

Startups must consider current market conditions and financial trends to ensure accuracy while estimating the cost of capital.

To sum up, startups need to know how to calculate the weighted average cost of capital for their business, analyse the results, and avoid common mistakes for better financial planning.

Limitations of WACC for startups

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Although there are so many benefits to calculating WACC for startups, there are also limitations they need to be aware of. Some of these include:

• It’s difficult to apply the calculation of WACC to a specific project as there may be different risk and return levels.
• Some inputs in WACC are difficult to measure in practice and in real-time business environments which impacts its accuracy.
• Different models yield inconsistent values when calculating a business's cost of equity, making it difficult to calculate.
• WACC assumes a fixed capital structure, disregarding changes in debt-to-equity ratios over time.
• Changes in external factors such as interest rates, market conditions, and economic trends can affect WACC causing it to fluctuate, thereby impacting financial plans.

How does the cost of capital vary for different startup types? 

The startup's cost of capital is dependent on the nature of the business, its stage of development, and its funding needs and each factor should be considered when seeking funding.

Early-stage startups may have a higher cost of capital than those that have already launched their product or service because investors are more inclined to fund those who have hit some early-stage milestones.

How does a startup's stage influence its cost of capital?

Early-stage startups rely on low-risk sources like personal savings. As they grow, they encounter higher risks and seek more costly funding from investors. Later-stage startups, facing the highest risks, incur the highest costs.

A startup's cost of capital impacts how much ownership they give up to fund operations. Higher costs mean giving up more ownership, while lower costs mean keeping more while still getting funds.

Startups should be aware of the risks associated with the specific stage they are in to make better decisions as regards investment opportunities.

Understanding the weighted average cost of capital (WACC) 

For startups, understanding WACC is important for strategic financial planning. Calculating WACC involves analysing equity and debt costs, along with their respective proportions in the capital structure. 

Though initially challenging, mastering WACC yields valuable insights for strategic decisions and financial improvement.

FFA offers more than capital; we are your growth partner, providing guidance and expertise to support your growth journey. Contact us today to learn how FFA can be your partner in achieving startup success.

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