Have you ever wondered how companies decide if a project is profitable or not? One of the most important indicators in this decision is the Weighted Average Cost of Capital, or WACC. Let’s break down what it is and why it is crucial for corporate finance.
WACC is a discount rate applied in company valuation and investment project analysis. It represents the return that must be achieved for the project to be feasible, create value, and cover financial costs and obligations to investors. In simpler terms, it is the minimum return that can be expected from a project without affecting its profitability. WACC is essential for making financial decisions and is applicable to any type of company, regardless of its size or industry.
The Weighted Average Cost of Capital considers the capital structure, that is, the proportion of debt and equity used. This means that it considers the money contributed by investors as well as the funds borrowed through loans. WACC is calculated as follows:
Where:
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on existing debt)
Tc = tax rate
Now let’s calculate the WACC of a tourism project in the Dominican Republic. For this, we need to find the yield on 10-year U.S. Treasury bonds, the yield on 10-year Dominican Republic sovereign bonds, the market risk premium, the industry’s beta coefficient, the average industry D/E ratio, the cost of debt, and the income tax rate.
After obtaining these values, we calculate the following:
- Country Risk Premium
Yield on 10 year U.S. Treasury Bonds – Yield on 10 year Dominican Republic sovereign bonds
6.61% – 4.65% =
1.96%
- Cost of Equity
Based on the CAPM (Capital Asset Pricing Model), the cost of equity is calculated as follows:
Rf + β (Em – Rf), donde:
Rf = Risk-Free Rate (U.S. 10-year Treasury yield)
β = Industry Beta (Industry Beta Coefficient)
(Em – Rf) = Market Risk Premium
However, to calculate the WACC for a project in the Dominican Republic, an additional risk associated with country risk, liquidity risk, regulatory and infrastructure risk, and market volatility is assumed. Therefore, we consider a country risk premium added to this equation. The adjusted equation would be as follows:
Sin embargo, para calcular el WACC de un proyecto en República Dominicana se asume un riesgo adicional asociado al riesgo del país, riesgo de liquidez, riesgo de regulación e infraestructura y la volatilidad del mercado. Por esta razón, consideramos una prima de riesgo país que agregamos a esta ecuación. La ecuación ajustada seria la siguiente:
Risk-Free Rate + Industry Beta * (Market Risk Premium + Country Risk Premium)
4.65% + 1.34 * (4.23% + 1.96%) =
12.94%
- Debt Component (based on industry average D/E)
Industry average D/E ratio / (1 + Industry average D/E ratio)
48.67% / (1+48.67%)
32.74%
- Equity Component (based on debt component)
100% – Debt Component (based on industry average D/E)
100% – 32.74%
67.26%
After performing these calculations, we obtain the necessary information to proceed with the WACC calculation:
Equity Component * Cost of Equity + Cost of Debt * (1 – Income Tax Rate) * Debt Component
67.26% * 12.94% + 8% * (1 – 27%) * 32.74%=
10.62%
WACC is an essential tool for evaluating the feasibility of projects and investments. It represents the minimum return that must be achieved for a project to be considered profitable. This indicator not only incorporates the costs of debt and equity but also considers additional factors such as the country risk premium, which is particularly relevant in markets like the Dominican Republic. Understanding and correctly calculating the WACC can make the difference between a wise financial decision and a poor one.