Energy Affordability - WACC and CAGR

WACC, CAGR

Contents

1. Introduction

2. WACC

3. WACC Example

4. CAGR

5. CAGR Example

6. Applications To The Energy Sector

7. Concluding Remarks

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Bitesize Edition

• There have been many examples, especially in nuclear energy, of projects experiencing cost and schedule overruns. As a result, I’ve decided to explore affordability metrics, today covering WACC and CAGR.

• As well as an example for each, I’ve then applied both these metrics to applications within the energy sector. How can the proportion of debt capital and equity capital used in a project affect a project’s affordability? How can WACC and CAGR work together to indicate which projects will provide shareholders with value? Find out more below!

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Introduction

Previously I’ve discussed net present value and the internal rate of return. If these posts interest you I’ll link them here!

Energy Affordability and Net Present Value - Part 1

Energy Affordability and Net Present Value - Part 2

Energy Affordability - Internal Rate of Return

For today, let’s commence the exploration into WACC and CAGR.

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WACC

The weighted average cost of capital refers to a company’s average cost of capital after tax. This includes all sources, including common stock, preferred stock, bonds, and any other form of debt. It’s the percentage rate that a company can expect to pay to finance its business activities. Shareholders, bondholders, and other stakeholders can utilize the metric to analyse if the capital provided to the company will see them gain their desired rate of return. Let’s take a look at the equation to better picture this.

\(\text{WACC} = (\frac{E}{V} * \text{Cost of Equity}) + (\frac{D}{V} * \text{Cost of Debt} * (1 - \text{Corporate Tax Rate}))\)

The first key takeaway is that we’re exploring the cost of each capital source as a percentage of the total capital.

The fraction E/V refers to the proportion of the company financed by equity, and D/V is the proportion of the company financed by debt. These figures are called the weighted value of equity capital and the weighted value of debt capital respectively. The sum of total equity and total debt is the total cost of capital. As a result, the equation below should always hold:

\(\text{Note}, (\frac{E}{V} + \frac{D}{V}) = 1\)

If the equation doesn’t hold, check you haven’t missed some debt or equity financing in your calculation.

As an aside, for anybody interested, we can calculate the debt-to-equity ratio with these metrics, which can be used to assess the financial leverage of a company. A good ratio is considered as a figure below 2. In context, this would be a company with debt that is double its equity. So, the company has £2 of debt for every £1 of equity. When looking at the financial statements, take total liabilities and total shareholder’s equity from the balance sheet to calculate this ratio.

A final aside, remember equity is assets plus liabilities. If not explicitly given the equity in an example, if you have the assets and liabilities, you can still complete the equation. Now, let’s go back to WACC with a calculation.