EME 801
Energy Markets, Policy, and Regulation

Weighted Average Cost of Capital


Weighted Average Cost of Capital

Now that we've covered the basics of equity and debt financing, we can return to the Weighted Average Cost of Capital (WACC). Recall the WACC equation from the beginning of the lesson:

WACC=(Fraction financed by debt)×(Cost of debt)×(1Tax Rate)+ (Fraction financed by equity)×(Cost of equity).

Evaluating the WACC for a company is different than evaluating the WACC for an individual energy project. When the WACC for a company is evaluated, we are often trying to determine (under imperfect information) what a company's costs of capital are. In this case, we would utilize as much financial data as possible in order to estimate the various terms in the WACC equation.

For an individual energy project, the various terms in the WACC equation are determined in large part by the type of investment being made, the type of market (regulated versus deregulated) in which the investment is occurring and the individual company or group of companies making the investments.

The tax rate term in the WACC equation may seem odd. Why discount the tax rate from the cost of debt financing? The reason is that from the perspective of a company, the interest on debt (i.e., the cost of debt) is tax-deductible, so interest payments are offset by tax savings.

Let's go through a hypothetical example to see how this works. Suppose that Mark Linguine PetroServices Amalgamated wanted to invest in a new oil refinery. What is the discount rate that Mark Linguine PetroServices should use in evaluating the NPV of the refinery project? The answer is that the discount rate is equal to the firm's Weighted Average Cost of Capital! So we need to calculate the WACC to determine the discount rate that Mark Linguine PetroServices should use.

Let's assume that 15% of Mark Linguine PetroServices' refinery activity would be financed by debt (just to use a single number). Oil company bonds have historically had very high ratings, so we'll assume that Mark Linguine PetroServices has a long-term bond rating of AAA. Looking online at corporate bond yields, we see that a 20-year AAA corporate bond would have a yield of 2.5% (as of the time of this writing - keep in mind that these rates can and do change frequently).

If Mark Linguine PetroServices faced a 35% marginal tax rate, then its cost of debt financing would be 0.025 × (1-0.35) = 0.02, or 2% (I'm rounding up here - the answer to more significant digits is 1.6%).

Turning now to the cost of equity financing, we need the return on the safe asset; the market risk premium; and the beta for the petroleum industry. The yield on the 30-year treasury bond was 2.34% at the time of this writing. We will assume a risk premium of 5%, and from the "Cost of Capital by Sector" web page we see that the beta for the petroleum industry is between 1.30 and 1.45 (the beta is in the second column of the table; we'll use 1.45 for this example). Thus, the cost of equity for Mark Linguine PetroServices would be 0.0234 + (1.45 × 0.05) = 0.1, or 10% (Again, I'm rounding here - the answer to more significant digits is 9.59%).

Assuming that 15% of the refinery was financed through debt and 85% through equity, the WACC for the Mark Linguine PetroServices refinery project would be:

WACC=0.15×0.02+0.85×0.10=0.095, or 9.5%

The WACC represents the discount rate that a company should use in conducting a discounted cash flow analysis of a given energy project. The reason is that the discount rate represents the opportunity cost of getting something in the future relative to getting something today. Since the WACC represents the average return for an energy project (remembering that that average is weighted across both debt and equity investors), it represents a kind of average opportunity cost for investment in a project.